How To Align Your Portfolio For The Fed's Taper

NEW YORK (MainStreet) — Earlier this year, the Federal Reserve began scaling back its bond stimulus by $10 billion per month, on the heels of improving economic conditions.

In her first Congressional testimony as the newly minted Federal Reserve Chairwoman, Janet Yellen announced that the Federal Reserve would continue tapering the bond stimulus, so long as the economic data and conditions warrant such action.

"If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back towards its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings," Yellen told Congress.

The Federal Reserve's bond stimulus, known as quantitative easing, boded well for investors in 2013, as it contributed to the Dow Jones Industrial Average's 27.5% gain and the S&P 500's 32% increase.

Those increases were an aberration and will likely be difficult to replicate in 2014. After all, the Dow Jones Industrial Average is already down 3.5% for 2014.

Since the Federal Reserve's stimulus is slowly starting to exit the markets, investors are scrambling to prep their portfolios for what is expected to be a turbulent year ahead.

Not to mention, a dearth of asset buybacks from the Federal Reserve will push interest rates yields to the upside, along with the 10-Year Treasury yield, which determines the interest rates on mortgages and credit cards, even though the Federal Reserve is not expected to change the federal funds rate any time this year, adding another level of complexity to asset allocation.

"It might be time to take some risk off the table, given 2013's gains, but we remain with a bias towards stocks," says Jeff Raupp, CFA and senior investment manager at Brinker Capital, a $16 billion investment manager. "If your time horizon is 6-12 months, you have to look at the markets in a positive nature, but you might have some more volatility from the taper."

For equities, returning to the basic principles of diversification can go a long way.

"The benefits of diversification are coming back to the forefront. Investors are finding out that the market doesn't just go up," says Kevin Mahn president & chief investment officer of Hennion & Walsh.

Sectors that have historically performed well in environment with an increasing yield on the 10-Year Treasury bond or when the Federal Reserve raised the federal funds rate, include energy, materials, information technology and consumer discretionary, according to Mahn.

As for bonds, Raupp cautions high expectations on returns, given the rise in interest rates over the next year. Bond prices and yields move in opposite directions.

"Instead of receiving 4 to 6% return, we're looking at a range closer to 2 to 3%, where you're just breaking even with inflation," Raupp adds.

To combat rising interest rates, Raupp is looking into bonds with shorter durations, which provides more protections in the event of a sharp and swift rise in rates.

Aside from the Federal Reserve's policies at home, don't underestimate the value of a portfolio with overseas exposure.

While stocks have benefited from quantitative easing, Japan is about to start its own version of a stimulus, which Raupp says will provide tailwinds for equities in Japan.

As for emerging markets, volatility in recent weeks has resulted in significant cash outflows from those regions. The Institute of International Finance expects capital inflows into emerging markets to fall almost 3.6% in 2014 to $1.079 trillion, from $1.119 trillion in 2013.

However, Raupp sees opportunities for long-term investors in emerging markets.

"Sometime in 2014, you'll see momentum stall in emerging markets and it will be a great place to move your assets to, if you have 3 to 5 years," Raupp said.

For the retail investor, worrying about the day-to-day market fluctuations is bound to make your stomach churn. For retirement accounts, approach your investments with a long-term perspective.

On the flip side, if you are watching the markets day-by-day, a classic way to gauge volatility in the markets is to watch the Chicago Board of Options Exchange Volatility Index (VIX), which uses the options market to gauge volatility over the next thirty days. For example, back on February 3, 2014, when the Dow Jones Industrial Average sank over 326 points, the VIX closed at its highest level in 13 months at 21.4.

- Written by Scott Gamm for MainStreet. Gamm is author of MORE MONEY, PLEASE

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