What Effect Will the Fed Have on Stocks in 2014?

It's difficult to overstate the grip the Fed now has on the "mind of Wall Street," to borrow the expression of Oppenheimer's Leon Levy. One of the primary unresolved questions is how the Fed will unwind its unprecedented experiment in monetary alchemy -- the bond-buying programs which have seen its balance sheet balloon to close to $4 trillion. This so-called "quantitative easing" is thought to have been instrumental in fostering a booming stock market -- the Dow Jones Industrial Average (DJINDICES: ^DJI  ) has risen almost 20% this year. But before one can unwind, one must first stop winding. As we look ahead to next year, that begs the question:

When in 2014 will the Fed begin to curtail its current bond-buying program?
First, notice the assumption contained in the question, which is that the Fed will begin to "taper" its bond-buying program in 2014. Is that a given? For goldbugs and other Fed detractors, it's an article of faith that quantitative easing has become a semi-permanent feature of the financial landscape that will run for years to come, but that's not what I'm suggesting.

Rather, I'm simply highlighting the (small) possibility that the Fed could begin tapering before 2014. Indeed, the Federal Open Market Committee, the group that sets monetary policy, will convene for one last policy meeting before the year is out, on Dec. 17 and 18.

Just two months ago, the Fed shocked financial markets at the outcome of its September policy meeting by deciding not to taper -- the overwhelming consensus among investors, analysts, and pundits was that the Fed was ready and willing to begin pulling back from its purchases. Two months on, the pendulum of market expectations appears to have swung excessively dovish, whereby the consensus now appears to be that tapering will start no earlier than March.

To consider an alternative scenario, one need go no further than the minutes of the September meeting (emphasis mine):

Conditional on their respective economic outlooks, most participants judged that it would likely be appropriate to begin to reduce the pace of the Committee's purchases of longer-term securities this year and to conclude purchases in the middle of 2014. A couple of participants thought it appropriate for the first reduction in the pace of asset purchases to occur later, and another specified that purchases likely would continue past midyear 2014; in contrast, a couple of participants thought that the program should be ended considerably sooner than the middle of next year.

I follow the coverage of the Fed closely, and I found only a single reference to this passage in the financial media (in the Financial Times, if you're wondering) -- perhaps because it was not contained in the minutes themselves, but rather in the "Summary of Economic Projections" that accompanied them.

Now, the national economy is not static, and we've experienced a government shutdown since the September meeting. This matters, as the qualifying clause at the beginning of the above quote -- "Conditional on their respective economic outlooks" -- ought to make clear. As such, I think it's unlikely that the Fed will decide to scale back its bond purchases in December (for myriad reasons), but it may be more likely than the market now believes.

That last observation is not that useful in itself because, either way, we're talking about low odds, but the market's excessively dovish attitude translates into an expected "taper" start date that has been pushed well into next year. I'm not sure why so many analysts appear to be looking out to the summer of 2014 and beyond. The March 18-19 meeting -- the first one associated with a Summary of Economic Projections and a press conference by the Fed chair -- looks like a good baseline to me at this stage.

What effect will the Fed have on the markets next year?
I think we can expect the market to continue to hang on every word from the Fed, and there is little question that the exit from quantitative easing will be an important theme next year. However, while I'm expecting some volatility around the taper itself (and around "mis-tapers" if the Fed surprises regard to the start date), it's not obvious that the Fed will have much impact on full-year returns. I think there is a growing acceptance that stocks are no longer cheap, and investors will increasingly need to justify the decision to buy stocks on the basis of valuation relative to earnings power.

With that said, some assets or sectors are certainly more vulnerable to a taper than others. Investors' favorite gold fund, the SPDR Gold Shares (NYSEMKT: GLD  ) , is prominent among these. It now looks like a virtual certainty that 2013 will be gold's first losing year in 13 years, and an exit from quantitative easing would provide a suitable catalyst for further price declines in 2014.

Another group of stocks that are vulnerable to the Fed's policy path next year are mortgage REITs due to their portfolios of mortgage-backed securities: The Fed's current round of quantitative easing has it purchasing $40 billion of mortgage-backed securities every month. Just look at the respective declines of 12%, 14%, and 19% in book value per share that American Capital Agency (NASDAQ: AGNC  ) , Annaly Capital Management (NYSE: NLY  ) and ARMOUR Residential (NYSE: ARR  ) experienced during the second quarter, when the idea of the taper was first floated, causing interest rates to rise.

Outside of these areas of froth (and a few others -- cough -- social networking), stocks look reasonably well-supported by earnings right now. Nevertheless, investors shouldn't expect the same level of returns in 2014 that we've enjoyed so far this year – regardless of when or how the Fed tapers.

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