Daily Gains Letter

These Companies Can Protect You from the Coming Market Decline

By for Daily Gains Letter |

Why Central Banks Have Encouraged RiskInvestors who love technical analysis must be having a sense of déjà vu. Whenever the Federal Reserve announces it’s ending its quantitative easing policy, the markets respond by cratering.

In March 2010, when the Federal Reserve announced it was ending its first round of quantitative easing (QE1), the Dow Jones Industrial Average and S&P 500 both fell 14% over the next three months. To help prop up the economy, the Federal Reserve initiated QE2 in November 2010 and concluded it seven months later. By early October, the Dow and S&P 500 had lost close to 15% in value.

In September 2012, the Federal Reserve initiated QE3—investors’ nerves were calmed when they discovered it was open-ended. Today, the Federal Reserve spends $85.0 billion a month on Treasury bonds and mortgage-backed securities to help prop up the American economy.

As I have been reading, that massive monthly cash injection doesn’t even begin to give the full picture of how much liquidity the Federal Reserve’s quantitative easing policies, and those of other central banks, are flooding the financial markets with.

Since the financial crisis began in 2007, the five biggest central banks have purchased roughly $12.0 trillion in assets. Coupled with the near-record-low interest rates, that accounts for about $33.0 trillion of fiscal and monetary stimulus spending—that’s about 46% of the global economy.

Suffice it to say, the Federal Reserve’s artificially low interest rates have made it easier than ever to borrow money, sending many international stock markets to new heights. And it’s from these dizzying heights that the markets are pondering the future of QE3.

While the Federal Reserve hasn’t said equivocally when it will be ending QE3, it did say it was likely it would start to taper it off in 2013 and would possibly end it in 2014. Again, we received no firm commitment from the Federal Reserve—just a hint. Even that was enough to put an abrupt end to the five-month-long rally.

This goes to show just how reliant the U.S. and the global economies have become on the central banks and their easy money. It also goes to show how much investors are going to have to modify their portfolio when the Federal Reserve grinds QE3 to a halt. The end of easy money will, as the history of quantitative easing has shown, lead to market volatility.

After a strong start to the year, a correction in the second half is not out of the question. Investors who have been heavily invested in defensive stocks and those that provide high-dividend yields may want to consider readjusting their portfolio, or at least considering those assets geared toward growth, like cyclical stocks.

Investors interested in cyclical stocks should look for companies with brand recognition, a strong international footprint, exposure to emerging markets, a cash position that allows it to grow, and potential for continued dividend growth.

If second-quarter earnings results are encouraging, it could increase America’s appetite for riskier stocks. At the same time, weaker results could derail any momentum. Still, as investors become more comfortable with the idea of risk, it’s more likely they’ll seek out those cyclical stocks that appear cheap relative to the rest of the market.

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