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Markets: (Mis)Interpreting the Fed

Since the minutes of the June meeting of the Federal Reserve's rate-setting committee were released yesterday, Kremlinologists -- er, Fed-watchers -- are in high demand. But before we get to those minutes, it's worth making one point: It should now be absolutely clear that financial markets overreacted last month to the June meeting statement from the Federal Open Market Committee and Fed Chairman Bernanke's attendant press conference.

Specifically, investors reacted with shock and awe at the notion that the Fed might begin to reduce its monthly bond purchases, a.k.a. "quantitative easing," as early as this year. Despite every effort by Mr. Bernanke, including the use of multiple analogies, he was not able to convince markets that a "taper" would not amount to tightening monetary policy or that the implementation of said taper remained contingent on continued improvement in the economy.

The minutes of the meeting ram this last point home:

"Many members indicated that further improvement in the outlook for the labor market would be required before it would be appropriate to slow the pace of asset purchases. Some added that they would, as well, need to see more evidence that the projected acceleration in economic activity would occur, before reducing the pace of asset purchases."

If there are still lingering doubts regarding the Fed's orientation, this statement by Bernanke in response to a question following a speech yesterday leaves little room for interpretation: "Highly accommodative monetary policy for the foreseeable future is what's needed in the U.S. economy."

And, lo and behold, buoyed (partially) by those clarifications, the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) are up 1.04% and 0.93%, respectively, at 10:15 a.m. EDT. By the look of things, the S&P 500 could make a new all-time high today. The Russell 2000 Index of small-cap stocks posted its fourth consecutive record high yesterday.

As far as stocks go, last month's sturm und drang was much ado about nothing. The volatility itself was nothing worrying -- the peak-to-trough decline in the S&P 500 was less than 6% -- but it is disconcerting to see how prone investors are to misinterpret and overreact to highly nuanced policy communications from the Fed. That's a crisis-management legacy that may be with us for some time, and one that could yet produce some fireworks in the months and years ahead as the Fed attempts to get back to a "normal" monetary policy.

In that context, investors would do well to hunker down and stay focused on competitive advantage, barriers to entry, and high returns on capital, rather than daily stock-price fluctuations. If you're ready to invest that way, The Motley Fool's chief investment officer has selected his No. 1 stock for this year. Find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.

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