NEW YORK (Reuters) - This you can bet on: The Federal Reserve will eventually stop its $85 billion-a-month bond-buying program, an economic lifeline aimed at getting the country back on its feet after the financial crisis.
While no one knows when the central bank will start winding down the quantitative easing that has pushed down interest rates, Fed Chairman Ben Bernanke hinted last week that the taps may start running dry sooner rather than later - perhaps as early as this summer.
The very thought sent a shiver through world stock and bond markets, though investors took some comfort after a closer look at Bernanke’s remarks and reassurances from European and Japanese central banks.
Markets got back on track this week on the prevailing view that Bernanke may not act all that soon after all. Still, the underlying message was clear: All good things must come to an end.
That said, there are ways to protect your portfolio and perhaps profit from the big shift. Experts recommend three strategies - a move into cash, alternative bond funds and buying shares that have lagged the recent run-up in stock prices - among other ideas.
Here are some tactics investors might consider as the era of quantitative easing ends:
The tapering off of the Fed’s stimulus program - which has pushed interest rates to historic lows - will cause bond yields to spike and prices to slump. The 10-year Treasury bond is yielding 2.17 percent, already up from 1.94 percent before Bernanke testified before a congressional committee last Thursday.
In a note last week, Goldman Sachs said bond yields are “distorted” and pegged the “fair value” - or the yield it would offer under normal market conditions - of the 10-year Treasury at 2.5 percent.
“We’re assuming that the yields are artificially low, and any kind of rate increase will really damage those funds,” said Chris Costanzo, investment officer at Tanglewood Wealth Management in Houston, Texas, a firm with $750 million in assets under management.
With that in mind, Costanzo has reduced his clients’ positions in U.S. stocks, increased the cash holdings of his conservative clients to as much as 24 percent of their portfolios and has moved out of bond index funds with large stakes in Treasuries. He said those moves will help protect portfolios in case the ending of the Fed’s stimulus program isn’t smooth.
The Standard & Poor’s 500-stock index could tumble once the Fed announces it is winding down its purchase program and bond yields start rising, said Uri Landesman, who oversees $1.2 billion at the New York investment manager Platinum Partners.
“When people pull out of the bond market, they are going to pull out of everything,” he said, adding that he believes the stock market has been “insanely” inflated by the Fed’s policies.
He expects the S&P 500 to trade at about 1,400 by October, a decline of almost 16 percent from Tuesday’s level of 1,660.
There are alternatives to stocks. Costanzo is adding to positions in “go anywhere” bond funds such as the $41.2 billion DoubleLine Total Return fund, whose 5 percent stake in Treasuries is just a third of the average of 16 percent among funds in its category, according to Morningstar.
Instead, that fund, whose three-year annualized return of 10.2 percent puts it in the top 2 percent of intermediate bond funds, holds large positions in “private label” mortgage bonds that are not backed by Fannie Mae or Freddie Mac.
These bonds have rallied as the housing market rebounded, and supplies have fallen to $909 million from a peak of $2.2 trillion in 2007. With few new bonds coming onto the market, the lack of supply will likely help keep prices steady even if the housing market cools, analysts say.
Typically, a stock market pullback helps boost prices of so-called defensive sectors - such as utilities, telecom companies and consumer staples - that are not as dependent as many other companies on a growing economy for profits. But this year those sectors have led the market. Investors already have turned to them as alternatives to the bond market.
Defensive sectors are “extraordinarily expensive,” said Burt White, chief investment officer at LPL Financial.
Slow-growing utilities, for instance, are trading at an average trailing price-to-earnings ratio of 16.5, while the S&P 500 as a whole is trading at a p-e of about 14. Over the last 10 years, utilities have traded at an average p-e of 14.1, according to a Fidelity Investments analysis.
By comparison, technology stocks, a growth sector in which investors typically pay more for future earnings, trade at an average of 15.1. Typically, that sector trades at a p-e of 20.
If the Fed does retreat, it will be because the economy is picking up steam. That is leading White and others to consumer discretionary stocks, even though those are already up about 20 percent this year.
“The consumer names will continue to do well, given that any pullback won’t be economic in nature but much more around the tapering of the stimulus,” he said.
Investors who want to bet on the sector could opt for an exchange-traded fund like the $843 million Vanguard Consumer Discretionary Fund. Costing 14 cents per $100 invested and yielding 1.3 percent, the ETF has its highest weighting in Home Depot, McDonald’s and Amazon.
Alan Gayle, who manages $325 million invested in four target-risk portfolios at Ridgeworth Investments, has been increasing his stake in technology stocks and other cyclical sectors for the same reason. Tech stocks are up about 9.9 percent for the year, lagging the broader market, and are poised to push higher should a growing economy nudge corporations into increasing their capital spending, he said.
Large financial firms may benefit from the end of the Fed’s program over the long term, said Ann Miletti, a co-manager of the $1.8 billion Wells Fargo Advantage Opportunity fund, which focuses on mid-cap stocks.
Miletti has added to positions in financial firms such as Ameriprise Financial and Lazard Ltd in anticipation of rising rates. Such a move would make money markets and other interest-bearing accounts more profitable without increasing costs, she said. Lazard is lagging the benchmark S&P by about six percentage points for the year and trades at a forward p-e ratio of 14.1.
Still, investors who make the “rising rates” play may have to wait for a while before the payoff, she concedes. Nobody knows when the Fed will act - just that it eventually will.
Reporting By David Randall; Editing by Linda Stern, Frank McGurty and Douglas Royalty