Heard Off the Street: Job well done, Mr. Bernanke, market overreaction aside

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Love him or hate him, one of Federal Reserve Board Chairman Ben Bernanke's toughest jobs is communicating what the central bank's policy -- meticulously crafted in highly nuanced language that's provided full employment for a cottage industry of interpreters -- really means.

By that measure, the statement the Fed issued Wednesday after a two-day meeting last week and the subsequent one-hour press conference Mr. Bernanke hosted qualify as a job well done.

Mr. Bernanke said that based on the Fed's current economic forecast, the economy is strong enough for the Fed to start reducing its $85 billion monthly purchases of Treasury and mortgage-backed securities later this year and to halt the purchases completely by mid-2014.

The Fed embarked on the buying to provide liquidity to the market, keep interest rates at historic lows and spur economic growth. Critics say all the purchases -- or "quantitative easing" in economicspeak -- have done is to artificially inflate stock and housing prices.

Perhaps if Mr. Bernanke had simply said "I've got some good news and I've got some bad news" -- that is, the economy is improving and interest rates are going up -- some people would not have been so bothered by the events that followed. After trading at even to slightly lower before the Fed announcement, the S&P 500 finished off 1.4 percent Wednesday and fell another 2.5 percent Thursday. Yields on the benchmark 10-year Treasury bond bounced higher, finishing Friday at 2.51 percent.

"If the Fed is right and the economy is doing better and that's why they are cutting back their liquidity provision, it certainly is good for the market long-term," said Geoffrey Gerber of Twin Capital Management in McMurray.

While Mr. Gerber and other market observers believe Wall Street's reaction was a tad excessive, they said it was not wholly unexpected. Everyone knew the Fed would ease back on quantitative easing eventually. Mr. Bernanke has indicated as much in recent weeks. Moreover, in a year when the Dow Jones industrial average has reached a new high nearly one out of every five trading days, a sharp pullback in stock prices could be expected.

"Some might say the market was due for a correction and was just looking for a reason, which Bernanke provided," Vista Investment Management's John Frankola said in an email.

Mr. Frankola noted that the last day the 10-year Treasury traded below a 2 percent yield was May 21. That was the day before Mr. Bernanke hinted that the Fed could curb its bond buying in testimony before the Joint Economic Committee of Congress.

In fact, the case could be made that bond and stock markets have been trending lower since Mr. Bernanke tipped the Fed's hand last month and that Wednesday's announcement only provided additional momentum.

The sharp market response should be viewed with some perspective. Interest rates remain well below historic averages and the stock market has still prospered this year. Based on Friday's close, the Dow has generated total returns (including dividends) of 14.3 percent this year. The comparable return for the S&P 500 is 12.8 percent.

Some believe all Mr. Bernanke's comments did was to take some air out of an inflated stock market. Even if the market fell slightly for the remainder of the year, stocks would still produce close to their historic average annual returns of 8 percent or so, Mr. Gerber said.

For Greg Melvin of C.S. McKee, stocks remain the preferred investment.

"You do not want to be in cash because you'll get zero. You don't want to be in bonds because you'll lose," said the Downtown investment manager.

One aspect of Mr. Bernanke's statement some overlooked is that the theoretical time frame for stopping bond purchases is based on whether the Fed's forecast holds. The Fed's consensus forecast calls for the unemployment rate, currently 7.6 percent, falling to 6.5 to 6.8 percent next year. That's a slight improvement from its March forecast. The Fed also believes inflation pressures will ease slightly.

"Our policy is in no way predetermined," he said during the press conference. "Our policies are tied to how the outlook evolves."

While some believe the forecast is too rosy, the inflation outlook troubles Ronald Heakins of OakTree Investment Advisors in Shadyside. He said it could lead to deflation, where consumers put off purchases because they believe whatever they want to buy -- whether it's a house, a car or something else -- will cost less in the future than it does now. That would cause the economy to slow and unemployment to rise, he said.

"That's the biggest concern I have," Mr. Heakins said.

Distracting as the market's reaction to Mr. Bernanke is, everybody knew the Fed's bond buying would eventually end and that when it did, interest rates would rise and stocks would have to stand on their own two feet. If the economy really is improving, long-term investors should ignore the headlines, said Daniel Henderson of Cookson, Peirce & Co., Downtown.

"The fact is, you needed this to happen. It indicates the economy in fact is getting better," he said. "Investors in general need to make plans decade to decade, not day to day."

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Len Boselovic: lboselovic@post-gazette.com or 412-263-1941.


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