Did Ben just kill the bull market?

The stock market has been on a tear, going almost straight up until May 22, when Federal Reserve Chairman Ben Bernanke first signaled that the Fed was considering tapering its massive bond purchase program.

At a press conference on June 19, the Fed Chairman further made it clear that the Fed could start as soon as the end of this year to reduce its monthly bond purchases. From June 19 to June 20, both the stock market and the bond market went downhill. Did Ben kill the bull market, or is the market is overreacting?

We need to look at the bond and equity markets separately. I believe the equity market is overreacting. Many investors are so addicted to the Fed stimulus program that they are ignoring the reason the Fed to is reducing its bond-buying.

The massive bond-buying program was implemented to stimulate the weak economy.  The Fed wouldn’t entertain the idea of taking its foot off the gas pedal if the economy was still weak. This year, many economic signals have shown that the economy is recovering. The housing market has become one of the fastest-growing sectors in the economy. The unemployment rate, at 7.5 percent, is still high but improved compared with last year.

Consumer spending, which accounts for approximately 70 percent of U.S. economic activity, grew at 3.4 percent. Corporate profits are at a near-record high. The most recent Fed statement concluded that “economic activity has been expanding at a moderate pace.”  The strengthening of economy should be a positive factor for the stock market.

In addition, one of the unintended consequences of the Fed’s stimulus is to enable government spending at the ultra-low interest rate. By gradually tapering off the monetary stimulus, government officials may finally have to do something to get our deficit under control and fiscal house in order.

The bond market could be a different story. For the last 30 years, investors have enjoyed a long bull market for bonds, mainly due to the declining interest rate. When the Fed tapers off its stimulus, the interest rate is likely to rise.

Bond prices and interest rates move in opposite directions: rising interest rate means lower bond price. A bond’s price sensitivity to changes in interest rates is referred to as its duration. The higher a bond’s duration, the more sensitive it is to changes in interest rates. This is called the interest rate risk.

The longer maturity bonds have a higher duration. For example: the 10-year bond will be more sensitive to interest rate changes than the two-year bond.  Since the end of April, all major bond indices have shown weakness. The iShares 20+ Treasury (TLT) fell more than 8 percent. Even the famed PIMCO Total Return ETF (Bond) fell more than 4 percent.

The consensus is that the secular bull market for bond is close to over. This doesn’t mean investors should bail out of bonds completely. Bonds and stocks serve different purposes in a diversified portfolio. In a rising interest rate environment, investors will be better off choosing bonds with short duration (one to two years) to help mitigate the interest rate risk.

Even though both the bond market and the equity market went down sharply on June 20, it seems to me that the Fed policy and its rationale should impact the bond market and equity market differently. I am still cautiously positive that the bull in the stock market has some way to go.

What should investors do? Building a broadly diversified portfolio is still prudent, logical and beneficial for the long-term.