What a Yellen Fed Means For Stocks

Janet Yellen will take charge of the Fed at a critical juncture.

Jan 7, 2014 at 10:15AM

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Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

One of the coldest Arctic outbreaks in two decades is bringing record low temperatures to the East, the South, and the Midwest, but investors' risk appetite isn't frozen, as stocks opened higher this morning. The S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES:^DJI) are up 0.61% and 0.72%, respectively, at 10:15 a.m. EST.

Perhaps one of the news items that is stoking the market's gains today is Monday's Senate confirmation vote of Janet Yellen to succeed Ben Bernanke at the head of the Federal Reserve, beginning on Feb. 1. The final tally of 56-26 (some senators were not in Washington for the vote due to the inclement weather) shows tepid support for Yellen -- by comparison, Bernanke's 2010 reappointment was controversial, but it was approved with a 70-30 vote. However, that matters little now that the Fed chair is hers.

Yellen takes this post at an exceptionally delicate juncture. The appointment of a woman is a historic milestone, but the Fed hit another milestone in December as its balance sheet topped $4 trillion in assets (more than those of JPMorgan Chase and Wells Fargo combined), having more than quadrupled in size since the start of the financial crisis. Yes, the central bank decided in December to taper its monthly bond purchases to $75 billion starting this month, but that amounts to lifting the foot from the accelerator, to use Bernanke's own analogy -- the Fed's balance sheet will continue to expand for some time yet.

Weaning financial markets off the stimulus it has provided could prove tricky -- while never failing to project confidence and authority, central bankers admit that they are in uncharted territory. Whether or not it is accurate -- and I suspect it is -- many professional investors believe the Fed's emergency measures, including three rounds of bond-buying and five-plus years of zero interest rates, have been a key driver of the spectacular bull market that has lifted the S&P 500 170% from its March 2009 low (not to mention the spectacular overvaluation in government bonds). That perception alone fosters a risk of withdrawal symptoms as the Fed takes a less interventionist role in markets.

In that context, what can we expect from Yellen? On the whole, continuity with Bernanke's regime; we know that Yellen, as Fed vice chairwoman, has championed asset purchases and a more open communication policy. She is also reported to be willing to tolerate inflation that is moderately above the Fed's 2% target in order to fight unemployment. That is enough to have her labeled a "dove" in the financial media, but my research suggests she is a pragmatic policymaker.

By and large, Bernanke did a first-rate job combating the crisis and its aftermath, but he leaves Yellen with some very heavy lifting. Even barring any major missteps from the Yellen Fed, I would suggest last year's stock market performance was partially borrowed from future returns. Anyone expecting a repeat performance (or anything near it) ought to take the rose-tinted glasses off; the potential for some genuine volatility in 2014 -- not just the kind that goes up -- looks excellent.

Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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