How to Navigate the Market in Spite of Bernanke

TheStreet.com

NEW YORK TheStreetTour de France commentator Paul Sherwen would probably say that Ben Bernanke threw a cat amongst the pigeons this week when he laid out a scenario where the Federal Reserve would slow down its asset purchase program later this year and end it sometime next year.

Presumably the Fed would stop asset purchases, which have been running at $85 billion per month, because the economy is showing signs of health. Of course, there is no way of knowing how healthy the economy would be had there been no asset purchase program. Some economic indicators, such as housing prices, have shown signs of recovery. They've come off a bottom but are still well below 2006 levels.

Some pieces of data have not recovered the way they should have, however. The unemployment rate is still more than 7% and would be higher had the labor force participation rate not contracted to 63%.

GDP growth has lagged behind past economic recoveries, as it has been in the 2% range. The Fed believes GDP growth is headed toward a 3% handle, which is difficult to see from here, especially if interest rates continue their move higher.

The clear winner from the last five years of unprecedented Fed policy has been domestic equities. The S&P 500 rallied 150% in 50 months. Treasury bonds have also had a heroic rally. The iShares Barclays 20+ Year Treasury Bond ETF rallied 46% in just two years into its July 2012 all-time high.

One way to think of the last few years is that the Federal Reserve has actually distorted capital markets. On one hand, the Fed said it was trying to stimulate economic activity to the point where economic growth would sustain itself. On the other hand, Chairman Bernanke has made several references to the wealth effect, which refers to the improved sentiment that comes from higher stock prices. The wealth effect references indicate the central bank was also targeting asset prices.

Whether asset prices were actually targeted, they have rallied in a way that seems inconsistent with the flow of economic data. If that is true, then it creates an expectation that when the Fed does stop injecting liquidity, asset prices will then be free to seek out their natural level. That does not have to mean lower prices, but lower prices do seem likely initially.

The last two trading days offer a glimpse of what could be coming when the Fed does cease its asset purchase program. Yet the market's behavior this week has been driven more by fear of the unknown than anything else.

Of course, that is normal market behavior. Markets panic when confronted with the unknown. Fortunately, this is market behavior we have all seen before and -- I hope -- is something we have all learned from.

In my articles on exchange-traded funds over the years, I have written about the importance of being overweight short-duration funds or individual issues in the fixed-income portion of a portfolio.

The yield has been low, but these funds will avoid the carnage that could be inflicted on funds like TLT. Some examples include BulletShares Corporate Bond ETFs from Guggenheim or the iShares AMT-Free Muni Bond ETFs. Both suites of funds allow investors to choose a maturity.

For example, all of the bonds in the iShares 2015 AMT-Free Muni Bond ETF mature in 2015, so the fund avoids reasonable interest rate risk.

Another possibility is the Market Vectors Investment Grade Floating Rate ETF , which obviously owns floating-rate debt. In the last few weeks bond funds of this sort have generally been up or down 0.50%, but FLTR has actually been up 4%, while TLT has dropped 14%.

Dividend-oriented equities likely wouldn't be able to sidestep a large decline caused by rising rates because they tend to be sensitive to interest rates.

A decline, however, does not necessarily mean the company is in trouble. Companies with decades of a track record of growing their businesses and dividends will continue to do so, and their dividends and any decline could be an opportunity to add to positions even if there are further declines ahead.

At the time of publication, Nusbaum had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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