The View from the Top?

A few weeks ago, the S&P 500 closed at a record high of 1669, while most recently the index has given back some of these gains. Naturally, investors may be concerned with how fast the market has gone up in the last 6 months, not to mention dire headlines predicting that with our current fiscal situation the only fate of investment portfolios is to go lower. While people may feel great about this recent charge, it also can create a swirl of questions:

• After such a strong rally, and with the federal deficit so large, won’t market chaos emerge soon, sending equities and bonds into a downward spiral?
  
• Should we sell our assets to take profits while we still can? 

But, perhaps you should take a step back for a moment and think about how you should react with your portfolio with some different questions:

• Has your time horizon been altered?
  
• Have your liquidity needs changed? 

If you have the same time horizon and liquidity needs as you did when you established your financial plan, chances are you shouldn’t be thinking “what’s going to happen to stocks this summer,”—you should be thinking, “what’s going to happen to stocks over the next five to ten years?”

I can’t predict when the market will break through the all-time record high it set a few weeks ago, and I’ll put money on the fact that you can’t either. As a prudent financial professional, what I can do is help prepare for what we know is inevitable – the rise of interest rates.

Interest rates have been at historic lows for a while now. The Federal Reserve has kept rates near 0 percent in an effort to inject liquidity into our financial markets by buying Treasurys, and most recently by buying Mortgage Backed Securities. When the Federal Reserve purchases these bonds from banks, banks are flushed with cash, enabling them to loan to consumers, in turn consumers are able to make purchases on big ticket items such as cars or appliances. Increased consumption helps businesses as they sell more goods and their profits increase.

The Federal Reserve has accomplished this, for the most part. Markets have reached record highs, corporations have attained record profits, consumer sentiment has climbed, and household net worth recently hit record highs as well. Unemployment has dropped 2.5% to 7.6% over the last 3 years. The Federal Reserve’s objective is an unemployment rate target of 6.5%, and a 2% inflation rate. Although it may take another year or two to lower the unemployment rate to the Fed’s target, there is the real possibility that the Fed could begin to sell their bonds back into the market before the unemployment target is reached.

Currently there is nearly $4 trillion on the Fed’s balance sheet, and in order to normalize this, the Fed will have to sell back these bonds, which will effectively start to increase interest rates due to the increased supply in the market. Increasing interest rates would lower bond prices. This could be a bit painful for the market, but if the Federal Reserve waits longer, the deficit will grow larger, and the impact on the market could be worse. The Fed has to be very delicate as to how to sell back these bonds. The bottom line is that no matter what method they use to reduce their balance sheet, bonds will be hurt, but there will be certain bond and equity sectors that will hold up better than others.

Time will tell, but a review of any potential exposure you may have is important now.