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How to Navigate the Market in Spite of Bernanke

NEW YORK TheStreetTour de France commentator Paul Sherwen would probably say that Ben Bernanke threw a cat amongst the pigeons this week when he laid out a scenario where the Federal Reserve would slow down its asset purchase program later this year and end it sometime next year.

Presumably the Fed would stop asset purchases, which have been running at $85 billion per month, because the economy is showing signs of health. Of course, there is no way of knowing how healthy the economy would be had there been no asset purchase program. Some economic indicators, such as housing prices, have shown signs of recovery. They've come off a bottom but are still well below 2006 levels.

Some pieces of data have not recovered the way they should have, however. The unemployment rate is still more than 7% and would be higher had the labor force participation rate not contracted to 63%.

GDP growth has lagged behind past economic recoveries, as it has been in the 2% range. The Fed believes GDP growth is headed toward a 3% handle, which is difficult to see from here, especially if interest rates continue their move higher.

The clear winner from the last five years of unprecedented Fed policy has been domestic equities. The S&P 500 rallied 150% in 50 months. Treasury bonds have also had a heroic rally. The iShares Barclays 20+ Year Treasury Bond ETF (TLT) rallied 46% in just two years into its July 2012 all-time high.

One way to think of the last few years is that the Federal Reserve has actually distorted capital markets. On one hand, the Fed said it was trying to stimulate economic activity to the point where economic growth would sustain itself. On the other hand, Chairman Bernanke has made several references to the wealth effect, which refers to the improved sentiment that comes from higher stock prices. The wealth effect references indicate the central bank was also targeting asset prices.

Whether asset prices were actually targeted, they have rallied in a way that seems inconsistent with the flow of economic data. If that is true, then it creates an expectation that when the Fed does stop injecting liquidity, asset prices will then be free to seek out their natural level. That does not have to mean lower prices, but lower prices do seem likely initially.

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