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Global Outlook

Janet Yellen’s Effect on the Market

June 25, 2014, Wednesday, 16:13 GMT | 11:13 EST | 19:43 IST | 22:13 SGT
Contributed by eResearch

Janet Yellen whispered the word "noisy" when describing her view of inflation, and the market proceeded to trade higher. Why?

The market interpreted the "noisy" comment as essentially signaling that the Federal Reserve is not going to let fluctuations in economic data get in the way of flooding the market with money. Like generals, Fed governors are hopelessly fighting the last war as opposed to the next one. Yellen's comment led investors to believe that the Fed will not be tightening anytime soon even if inflation ticks up for a quarter or two.

Effectively, she told the market that the era of easy money is here to stay. The punch bowl at the party is here even if the guests start acting a little woozy.

Why Should This Concern Us?

It is apparent that the turmoil of 2008 is looming very large in the mind of every central banker from the U.S.A. to Europe to Japan. This time, the mistake is not going to be that the central banks will do too little. The problem is that central banks and Yellen are going to do too much. As a result, when the next recession hits, as it inevitably will, the central bank will be out of ammo.

Worst Case Scenario

As I have said numerous times, the most frightening prospect for the stock market is to have a recession hit in a period that coincides with rising interest rates. The good news is that, currently, neither element of this scenario looks likely to materialize. The bad news is that, the longer the Fed keeps interest rates low, the greater the likelihood that this scenario will strike us.

Basically, the 1st quarter GDP growth pullback that was due to the harsh winter is going to result in stronger GDP growth in the second half of 2014, amounting to 3.4%. I am confident that the economy will continue to recover because, if it was not already occurring, the S&P 500 would not be hitting new highs.

The question, of course, is will the economic recovery result in incomes rising? I am encouraged that employment is growing faster than expected, and a slow-growth recovery is generally beneficial for the market.

How Does a Slow-Growth Economy Help the Stock Market?

Our relatively muted recovery is causing interest rates to remain low. Lower-than-previously expected interest rates means higher stock prices. Essentially, the central bankers around the world are going to continue to keep interest rates low and asset prices high in order to try and cause the economic recovery to continue to accelerate.

This is good news for investors and bad news for savers because it helps those who invest in the stock market and hurts those who keep their money in CDs.

However, I remain concerned that, eventually, interest rates must rise. Prior to the 2008 crisis, the ten-year treasury rate was around 5%; currently, it is under 3%. If you take a step back from the daily fluctuations, you come to the conclusion that, if the economy returns to the growth level it was at prior to 2008, then interest rates are likely going to be rising.

The Sin of Trying to Do Too Much

Collectively, that is where the central banks have erred. There has been too much quantitative easing, and interest rates have remained too low for too long. The balance sheets on central banks are too big, and there is definitely too much money sloshing around the system.

This mistake is being made by every developed country in the world at the same time. The problem is that when the U.S.A. keeps interest rates low, and Japan does not follow suit, the Yen will appreciate relative to the U.S. Dollar. This would make it harder for Japanese companies to sell exports. Thus, world trade is forcing those nations which do not want to keep interest rates low to set them lower. Their alternative would be to lose exports to those countries that are actively lowering interest rates.

As a result, when the next recession hits (which it eventually will), the global consequence is going to be pretty bad. If a geopolitical war caused a spike in oil prices right now, there is not a central bank in the world that is in a position to help the economy.

My concern is that the boogey man of 2008 so traumatized the central bankers that they have over-reacted. As a result, asset prices may, in fact, steam upward in the short-term. If I am right, and central banks worldwide continue to over-react and keep printing money like it grows on trees, the short-term outlook for stock market growth may be conservative.

Frankly, I do not know when the next global recession will hit. It may start next week, next month, next year, or even five years from now. I do know, however, that a recession will eventually occur, and I also know that it is likely that no central bank is holding back monetary stimulus for that eventual day.

Like the fable of the ant and the grasshopper, all the major world economies are only worrying about the present, and they are not saving their monetary policy for the future. The crisis scared everyone too much. It exposed the fragility of the financial system and all the policy makers are over-reacting.

Where Is the Stock Market Headed?

As a result, we are going to have a much easier time in the stock market for the immediate future. Janet Yellen is going to print money regardless of what the pesky inflation number is - data be damned. Unfortunately, when the next recession hits it will likely be quite a doozy. The reason is that, when it hits, the Federal Reserve will be out of ammo.

We just released Zacks' new market outlook report for July, and I have arranged for you to download it free. It contains our predictions about where the economy is heading as well as what that projection means for the stock market.

Many of these predictions, including what we see for 2nd quarter growth, may surprise you and I suggest you consult them now.

But, remember, investing in the stock market is a micro not a macro game. You do not make money in the stock market by trying to time the market or reacting to the Federal Reserve. You make money by buying companies that have received upward earnings estimate revisions and are, thus, statistically more likely to receive upward earnings estimate revisions in the future.

However, now would be a good time to lean a little bit more towards companies without so much debt on their balance sheet, and whose earnings are high quality based on a measure such as earnings accruals. Ignore the recent market strength. Keep the asset allocation in-line with the risk level.

Most of all, stay informed and up-to-date.