Where should investors be when QE really starts to wind down?
As investors prepare for any utterance of the words "taper" or "tighten" from Federal Reserve Chairman Ben Bernanke, it's a good time to take a step back and reconsider portfolio allocations.
Which sectors stand to gain or lose the most? Developed or emerging markets? High-yield corporate bonds or investment-grade Treasurys?
Fortunately, it's not hard to imagine how markets will react to stimulus reduction: We got a glimpse of that reaction in late May and June when Bernanke simply alluded to tapering in the latest minutes from the Fed's policy arm, the Federal Open Market Committee (FOMC).
So what did that preview tell us when global financial markets briefly went haywire?
First and foremost, it told us which sectors to avoid. For the most part, it's the usual suspects: real estate, energy and consumer cyclicals—especially retail and leisure/recreation.
Those FOMC minutes were released on Wednesday, June 19, so I assessed the return on more than 50 ETFs—each as a proxy for a sector, asset class or size/style bucket—from the previous day's close (June 18) to the end-of-week (June 21) close.
Of course, factors other than "taper-talk" were at play over that time period as well, but the insight is useful nonetheless.
Building and construction was among the biggest losers. Mere whispers of a reduction in quantitative easing caused the PowerShares Dynamic Building & Construction ETF (NYSEArca: PKB) to stumble more than 6.50 percent over a few days.
When the Fed talks about tapering QE, it's talking about reducing its monthly purchases of mortgage-backed securities and Federal Reserve notes.
As we can see below, it makes sense that building and construction would be hit hardest.
|PKB||-6.51%||Building & Construction ETF|
|Lumber Liquidators||-13.31%||Wholesale hardwood floors|
PKB's performance was dragged down by some of its largest holdings such as Pulte Group (NYSE: PHM), one of the nation's largest homebuilders, and Lumber Liquidators (NYSE:LL), a hardwood floor company that's at the intersection of basic materials and homebuilding—an unfortunate place to be when stimulus is slowing. Both holdings were down more than 12 percent over the observation period.
Other real estate ETFs felt the pain as well: The iShares U.S. Real Estate ETF (NYSEArca: IYR) and the Vanguard REIT ETF (NYSEArca: VNQ) each fell more than 5.50 percent over the same period.
After the mid-June sell-off, Bernanke was eager to clarify that tapering is not the same as tightening (raising interest rates). He's right; they're not. They do, however, represent different degrees on the same spectrum.
As the diagram below explains, energy is another common victim of rising rates and/or slowing stimulus.
If you expect the economy to grow faster than consensus expectations, going long energy is not a bad play.
However, when the Fed steps in to raise interest rates and slow economic growth, the popular adage "don't fight the Fed" comes to mind. Even if fundamentals appear strong, betting against the Federal Reserve has generally been a losing wager.
Unsurprisingly, energy exploration and production—a higher-beta subset of the broad energy sector, was hit hard by Bernanke's statements: The SPDR S&P Oil & Gas Exploration and Production ETF (NYSEArca: XOP) fell 5.28 percent over the observation period.