The Fed as Catalyst

We had a piece all ready to run this morning about churning on the indices, especially the NASDAQ, which prior to today closed tightly for several sessions on elevated volume. That’s a sign that longs are taking profits under the cover of strength from late comers. It normally precedes a price correction.

We felt the indices might be vulnerable and that we had the catalyst: the Fed’s upcoming announcement at 2:15 pm EDT Wednesday.

And then the market gapped higher today and the indices rose, the NASDAQ to new recovery highs on continued good volume. Such is the strength in the current market environment that “smart money” taking profits hasn’t been that smart after all. And so called smart bloggers have to rework their not so wonderful columns.

But we do feel investors would be remiss not to lighten up on underperformers in their portfolios. The market is extended and while we expect any correction to yield to higher prices sluggish stocks could be vulnerable to a more severe decline.

Why are we of the opinion the FOMC announcement could be a profit taking event? After all Fed days have been non-events for the most part during the rally as interest rates are at zero, the Fed has indicated it intends to keep them there “for an extended period,” and the market has gorged on the liquidity.

But for the second meeting in a row rumors from reliable sources are floating about the imminent beginning of the Fed’s exit strategy from their liquidity policies. Last month we wrote a column on former Fed governors opining that quantitative easing would be ended. They were misinformed. Now tonight Bloomberg is citing “people with knowledge of the discussions” that the Fed has started talks with bond dealers about withdrawing some of the liquidity they have pumped into the system through reverse repurchase agreements, although the timing for this is not indicated.

It is highly unlikely that the Fed wants to upset the markets at this juncture. With the financial system recovering and interest rates at record low levels many banks are in position to make enough money to heal their wounds. But with the economy clearly starting to recover the velocity of all the money pumped into the system will increase and with it the risk of inflation. The performance of the dollar and gold these last weeks has told us that.

If the Fed is impolitic it could scare a market that is well extended. Of course our concerns could well be misplaced and the market that much higher tomorrow evening. We hope so. But with good gains under our belts don’t forget to weed the weaklings in your portfolio ahead of a potentially actionable event.