With the exception of a rough first half of October, the stock market has been nearly unstoppable since hitting its March 2009 lows. The Dow Jones Industrial Average, S&P 500, and Nasdaq Composite have risen a mind-boggling 170%, 205%, and 265%, respectively, and investors who have stayed long have been greatly rewarded.
A lot of factors have gone into the markets' rebound, including an improving U.S. economy, lower unemployment rates, rising home prices, and record-low lending rates, which encourage businesses and consumers to borrow and spend. But as much as anything else, the Federal Reserve has played a key role in stabilizing the U.S. economy and calming investors' nerves over the past five-and-a-half years.
Through three versions of quantitative easing, herein known as QE, the Fed has injected around $3.6 trillion into the U.S. economy with the express intent of loosening credit markets and encouraging banks to lend, especially in the housing market, which was an absolute mess when the Fed first began injecting money into the U.S. economy. You could argue that the central bank of the U.S. succeeded with its three versions of QE, as home prices are on the rise and 30-year mortgage rates are still near historical lows, though the true success of all three QEs as a whole is still up for debate.
In the latest round of QE, which was officially ended in October, the central bank purchased $85 billion worth of mortgage-backed securities and long-term U.S. Treasury bonds each month at its peak. QE was, for lack of a better phrase, free money for investors. It was a calculable and repeatable monthly stimulus that investors counted on to help keep lending rates down and encourage consumers to buy homes and refinance their mortgages, as well as push businesses to take on fresh debt, refinance existing debt, and expand their workforces.
However, with QE3 now over, investors should be prepared for a big change in the way they think about the U.S. economy.
The critical change investors need to be aware of
While QE was still on the table, investors looked at economic data very differently from how they have in the past. QE was a stimulus, plain and simple. And as a stimulus to the U.S. economy, it could only continue so long as there was negative economic data. In short, bad economic reports -- e.g., weaker-than-expected jobs growth, slowing GDP growth, rapidly rising inflation, etc. -- were actually good news for investors, because it meant the Fed had no reason to take QE off the table.
On the flip side, good economic news, such as a multiyear low in the unemployment rate or steady growth in U.S. GDP, was actually construed as bad news for QE -- the idea being that there's no need for a monthly stimulus if the economy can stand on its own two feet.
And now, for the first time since the Great Recession, good economic news is once again good news for investors, and bad economic news is, in fact, bad.
Let me be clear: This is a good thing! The backward logic that has persisted for the past five-and-a-half years is unprecedented and somewhat maddening to a skeptical investor like myself. Further, investors can now stop second-guessing long-term economic trends and actually dig into monthly and quarterly economic data to get a true feel for the health of the economy. With QE no longer shielding investors from positive or negative data, if the U.S. economy really has turned the corner, it should allow the market to see ample upside potential in the coming years.
Stay the course
Does this mean you should sell everything you own after one bad jobs report? Probably not. Chances are your investing thesis for the companies you own has not changed since QE3 was put to rest a month ago.
However, it doesn't mean the dynamics of your holdings won't change. It's quite possible that as investors readjust to how they should think about the economy, market volatility and pricing premiums could increase. Given the huge upward run in the stock market over the past five years, cheaply valued stocks could be few and far between. For investors, this means taking extra time to do your homework and ensure you're buying quality stocks for the long term and not being lured in by volatility or emotions.
It also means investors need to once again be able to identify the difference between fleeting trends and long-term trends. Recessions, for example, are a natural component of the economic growth cycle, and trying to time your investments around these fleeting events is often a losing proposition. Over the long term, though, investors who have stuck with their holdings through the good and bad times usually come out ahead. Let's not forget that the stock market has returned an average of close to 10% per year over the long run.
In sum, get ready for things to make sense again, but be sure you're sticking to your long-term investing thesis in order to get the best results.