Scenario One: If the markets believe the underlying economy is strong enough, interest rates will rise and the stock market should continue to rise as well.
Scenario Two: If the markets believe the primary reason for tapering is fear of asset bubbles rather than economic confidence, the risk-off trade may rear its ugly head.
The markets, and our portfolios, are currently aligned with Scenario One. However, interest rates appear to be near a possible inflection point (see chart below). If fear allows Scenario Two to take the driver’s seat after the Fed begins to taper, interest rates may fall and stocks could begin a sideways-to-down trend as they did near points A1 and B2.
If Scenario One continues to carry the day, we are properly positioned in stocks (VTI), and leading U.S. sectors, including small caps (IWM) and technology (QQQ). Our exposure to emerging markets (EEM) and a diversified basket of foreign stocks (EFA) is also appropriate under Scenario One conditions. If Scenario Two begins to take hold of the market’s asset pricing mechanism, our market model will allow us to prudently migrate away from stocks (SPY) and toward more conservative assets, such as bonds (AGG).
This article is brought to you courtesy of Chris Ciovacco from Ciovacco Capital.