What Will You Do When the Fed's Easing Ends?

NEW YORK (TheStreet) -- The Federal Reserve announced another $10 billion reduction in asset purchases -- also known as quantitative easing, or QE -- last month, bringing total purchases down to $55 billion per month. Most investors are currently expecting the Fed to continue its tapering in the coming months and to completely wind down its latest round of quantitative easing by October of this year.

As for the market's reaction, investors still seem quite sanguine that the winddown will be orderly. The CBOE Volatility Index (VIX.X) is currently in the mid-teens, the equity put/call ratio is at the lower end of its historical range, and active managers in the National Association of Active Investment Managers continue to report high exposure levels to the market, as you can see in the chart below.

This complacency persists in spite of the fact that the S&P 500 is flat on the year and the Russell 2000 is down close to 3%.

Why are investors so optimistic? In a word: conditioning. They have been told in no uncertain terms not to "fight the Fed" and that the "Fed put" will be there should any declines ensue. It has been almost two years now since we have seen a 10% correction in the S&P 500, a long time to build up confidence in the Fed's ability to prevent declines.

Additionally, since the beginning of 2013, every dip has been an easy dip to buy, with the S&P 500 running straight up to new highs once a short-term low is reached, as you'll see in the chart below. This pattern is a classic example of a positive feedback loop where investors have been continually rewarded for buying into any short-term weakness.

When does this positive feedback loop end? When market participants are punished for buying the dip. Plainly, this occurs when the market does not run straight up to new highs but instead fails at a lower high, followed by a sharp move down to a lower low.

Most are assuming this will not occur until after October because this is the pattern we observed following the end of QE1 in 2010 and QE2 in 2011. In those years, shortly after the QE programs ended, a deep correction ensued: a drop of 17% in 2010 and another drop of 21% in 2011.

Will it be as simple this year? I highly doubt it. As game theory dictates, some market participants will inevitably cheat, seeking to get ahead of any selling that could follow the end of QE. We may already be seeing this as the broad market indices have struggled thus far in 2014 and widely held hedge fund positions have fared much worse.

The "smart money" is likely already selling.

While the selling may not reach the levels of 2010 and 2011, at the very least market participants should be prepared for higher volatility in the coming months. Our ATAC models used for managing mutual funds and separate accounts are currently reflecting this view and are defensively positioned.

Whether you believe in the concept of a "Fed put" or not, the prospect of an end of QE and possibly higher rates in 2015 is likely to change the psychology of the market. And as we all know, in the short-run the market trades primarily on psychology.

Buckle up, it's about to get interesting.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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