Hutchens Investment Management: Now you see it, now you don’t

 
CONCORD, N.H. - May 21, 2013 - PRLog -- While everyone has an opinion of what happens to QE3, the mechanics of the exit show no clear direction.  All we seem to know is that it is marching to extinction.  The Fed will move when they believe the economic foundation is secure enough to withstand any “shocks” to the system.  In actuality, the prognostications range from dire consequences to smooth transition.  When the course of action is finally determined, stock market reaction will be short-term at best.  We believe that the brief sell-off will be buttressed by the fact the winding down is being accomplished in an environment characterized by a larger than anticipated decline in the federal deficit accompanied by low inflation.  

Currently QE3 purchases $85 billion monthly ($1.02 trillion annually) of Treasuries and mortgage securities.  The common knowledge depicts a two party market in which the Treasury is selling and the Fed is buying.  This results in the misleading confusion of who will fill the void if the Fed stops QE.  In actuality, the average daily trading volume of Treasuries is $550 billion ($132.2 trillion annually) with Fed participation less than 1%, even on a big day.  Furthermore, the Fed does not participate in regular auctions.  Considering the magnitude of the overall market, Fed tapering sales should result in only a slight shift in the supply/demand curve with a marginal increase in supply.  To determine the potential of a Fed unwinding of its balance sheet we can examine the cumulative purchases.  According to Chairman Bernanke in his speech in Jackson Hole on August 31, 2012: “Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the Maturity Extension Program, found total effects between 80 and 120 basis points on the 10-Year Treasury yield.”  Today that yield is 23% higher than when the Chairmen spoke last year.

The most recent estimate for the current year federal budget deficit is $642 billion.  At this level the current QE program not only monetizes the deficit but also picks up an additional $400 billion in new debt.  Granted Fannie Mae and Freddie Mac are turning excess profits over to the government. Tax receipts are expected to increase. Five years into the bull market and with stocks at record levels, most capital loss carryforwards have been used, resulting in many investors paying capital gains rates as high as 23.9% instead of 15%.  Other new taxes include CEO options and for fiscal 2014 higher taxes on hedge funds and money managers.  We expect the economy to grow out of the soft patch in the second half of 2013.  In the US growth will be led by a resurging consumer, capital investment in durable goods industries, and housing.  With price/earnings ratios not reflective of sub 2% Treasury yields, we anticipate a continuation of the bull market for equities with minimal disruption from an orderly exit of QE3.  

Our investment strategy remains a full position in equities.  The run-up since the beginning of the year and a more bullish sentiment for equities opens the possibility of a correction.  Longer term earnings growth should accelerate later in the year as private economy growth accelerates.  Along with a dose of inflation this may be the ultimate catalyst for a sustainable bull market and deficit reduction.
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