AAII Investor Update: The Dovish Fed and Your Investments

Thursday, January 26, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Changes in Fed policy have historically impacted stock prices.

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 48.4%, up 1.2 points
  Neutral: 32.7%, up 3.5 points
  Bearish: 18.9%, down 4.7 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Yesterday, the Federal Open Market Committee (FOMC) voted to keep its interest rate target unchanged through at least late 2014. Just last month, the FOMC listed mid-2013 as the possible date for the first rate increase.

Behind the decision were worsening concerns about the economy. The FOMC signals changes in its outlook by altering the wording in its post-meeting statement. You can see examples of this in differences between the wording of yesterday’s statement and that of December 13, 2011:

  • Growth in business fixed investment—December: “appears to be increasing less rapidly;” January: “has slowed.”
  • Inflation—December: “has moderated;” January: “has been subdued”
  • Economic growth expectations—December: “moderate pace of economic growth;” January: “economic growth over coming quarters to be modest”

Committee members lowered their economic growth forecasts for both 2012 and 2013. Gross domestic product (GDP) is now projected to expand between 2.2% and 2.7% this year, versus November’s forecast for 2.5% to 2.9% expansion. For 2013, GDP is forecast to expand between 2.8% and 3.2%, versus November’s forecast of 3.0% to 3.5% expansion. Inflation is expected to remain at low levels, but unemployment high.

The Federal Reserve also released information about each committee member’s forecast for when interest rates will be raised. Out of the 17 members, nine currently anticipate leaving the federal funds rate target unchanged until 2014 or 2015. Two others think the accommodative stance could be unchanged until 2016. You can see the forecasts on the Federal Reserve’s website.

The dovish policy will have a mixed impact on your net worth.

To the extent that the FOMC’s economic forecasts are correct, the U.S. will avoid both a double-dip recession and an inflationary environment. If the forecasts are wrong, inflation could rebound strongly or current monetary policy won’t provide enough stimulus to prevent another economic calamity from occurring.

Bond prices should not experience much downside pressure over the foreseeable future. (Bond prices and interest rates are inversely related; stable to falling interest rates are good for bond prices.) Companies and municipalities will continue to be able to lock in low interest rates on new debt. The flip side of this is that it will remain a lousy environment for savers. Those of you who own maturing bonds will have to make a choice between reinvesting at lower interest rates or taking on more risk to get a higher yield. Not a pleasant choice.

The impact on stock prices is more complicated. Slow economic expansion will hurt earnings growth, especially since companies have already cut costs. Low interest rates will continue to limit interest income at time when corporate cash balances remain high. Extended dovish monetary policy also reduces long-term price targets, thereby adversely impacting valuations. (Analysts often use Treasury bond yields when calculating price targets for stocks.) On the other hand, financing for capital investments (e.g., construction of a new facility) and acquisitions will remain historically cheap. Plus, to the extent that a recession is avoided, profits, and thereby stock prices, will benefit.

The proverbial wrench in the works is if the FOMC is making the wrong assumptions about the economy and the direction of interest rates. Even though Federal Reserve officials see a lot of data, they are not clairvoyant. Thus, the margin for error is large. So keep your fingers crossed and your portfolio diversified.

More on AAII.com

We have published a few articles about the impact of the Fed on investors, and the two below are among the most recent. Take into consideration their publication dates when reading them.

Also of note on AAII.com:

AAII Sentiment Survey

Bullish sentiment stayed near 50% for the fourth consecutive week in the latest AAII Sentiment Survey. Bearish sentiment is unusually low for the third time in four weeks.

Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded to 48.4%, an increase of 1.2 percentage points. This is the sixth time in seven weeks that bullish sentiment has been above its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, rebounded by 3.5 percentage points to 32.7%. This is the fourth time in six weeks that neutral sentiment has been above its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell to 18.9%, a decrease of 4.7 percentage points. At more than one standard deviation below average, readings at this level are outside of the typical range for bearish sentiment we have seen over the survey's history. The historical average is 30%.

AAII members continue to remain optimistic about the short-term direction of stock prices. Though bullish sentiment is high, it is still within the range of optimism typically registered in the survey. A bullish sentiment reading above 50% would be considered unusually high, and a reading above 60% would be extraordinarily high, potentially signaling too much exuberance.

This week's special question asked AAII members what factors are causing them to be bullish, neutral or bearish. Respondents credited signs of an improving economy followed by better corporate earnings as the primary reasons for their optimism. Bearish respondents most frequently cited Europe's sovereign debt problems, followed by the economy, the federal deficit and Washington politics. Here is a sampling of the responses:

  • “The economic indicators are getting better; there is no choice but to turn bullish.”
  • “I’m bullish because of rising employment, the improving housing market and better corporate earnings.”
  • “The situation in Europe remains a overhang on the market.”
  • “Europe’s problems and congressional infighting are going to keep the market in negative territory over the next six months.”
  • “With the elections in the U.S. and the problems in Europe, I think the ups and downs will even out.”
  • “We are at resistance and I don't think the current global economic conditions will let the market go up much more.”

» Take the sentiment survey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor