Dow Down as Meeting Minutes Show Fed Worried About Overvaluation

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.

The Dow Jones Industrial Average (DJINDICES: ^DJI  ) was down 10 points to 16,454 at 1:30 p.m. EST on a light news day, with 17 of 30 stocks in the red. The S&P 500 (SNPINDEX: ^GSPC  ) was unchanged at 1,837.

The weekly initial jobless claims report for the week ending Jan. 4 came in at 330,000. That's in line with analyst expectations, roughly where it has been averaging for the past year, and exactly the level of the year-to-date average. Terrible jokes aside, the jobless claims report gave us no new information. Economy watchers are waiting for tomorrow's Labor Department nonfarm payrolls report for December, as well as any revisions to the reports from the past few months. Yesterday, ADP's private-sector employment report covering November and December came in well above analyst expectations, with roughly 238,000 jobs added each month.

Better-than-expected jobs reports raise the chances the Federal Open Market Committee will further pull back its economic stimulus going forward. Yesterday, the Federal Reserve released the minutes of the Dec. 17-18 FOMC meeting. The minutes state "participants generally anticipated that the improvement in labor market conditions would continue, and most had become more confident in that outlook. Against this backdrop, most participants saw a reduction in the pace of purchases as appropriate at this meeting and consistent with the Committee's previous policy communications."

The committee has said it would maintain asset purchases until unemployment hit 7%, at which point it would start winding them down as unemployment moved toward the target of 6.5%. Committee members voted last month to taper asset purchases by $10 billion, to $75 billion a month plus reinvestment of proceeds from its investments. The taper was more symbolic than anything as the effect of $90 billion a month in purchases versus $100 billion is minor, especially compared to the Fed's portfolio of $4 trillion in assets.

Members were not particularly concerned with the low level of U.S. and world inflation. The minutes note that "participants anticipated that [inflation] would move back toward 2 percent over time as the economic recovery strengthened and longer-run inflation expectations remained steady." Deflation would be a big challenge for the U.S. economy, as it makes paying back debt an increasing burden on those who are leveraged. I believe we will see labor inflation increase as unemployment continues to fall and companies have to raise wages to attract workers.

The FOMC members, according to the minutes, were worried about "the rise in forward price-to-earnings ratios for some small cap stocks, the increased level of equity repurchases, or the rise in margin credit. One pointed to the increase in issuance of leveraged loans this year and the apparent decline in the average quality of such loans."

What's an investor to do?
I continue to believe the stock market is overvalued and that earnings look cyclically high. That said, predicting where the broad market will go in the short term is a game for fools (with a lowercase "F"). Stocks can always get more overvalued. When things get frothy, it's worthwhile to build up some cash on the side for when prices inevitably fall.

The Motley Fool has always taught that Foolish (capital "F") investors don't invest in the broad market. We invest in great companies at good prices, continue to educate ourselves, and hold on to our great companies over the long term. The market will fluctuate (sometimes massively), but great companies will win out over the long run.

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