During the Fed's last taper, the S&P 500 gained 15% in a broad advance

Published Fri, Nov 5 20216:38 AM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Stocks are likely to continue their march into record territory and take the Federal Reserve's move to end its easy policies in stride, unless inflation becomes more problematic and threatens to speed up Fed tightening. Stocks rallied Wednesday and were mixed Thursday, following the Fed's announcement it would begin to taper back its bond purchases. The central bank plans to reduce its bond purchases by $15 billion a month and end the wind down of the $120 billion a month program by the middle of next year. The S & P 500 rose 0.4% Thursday, finishing at a record high. The Nasdaq was also at a new record but the Dow closed slightly lower. "We are in that six months of the year when the market tends to do very well," said Sam Stovall, chief investment strategist at CFRA. "Since 1990, the S & P gained 7.2% November through April but only 2.4% from May through October." Stovall said stocks do have a track record of performing well during Fed tapering. For instance, in the period between December, 2013 and October, 2014, the Fed tapered back quantitative easing and stocks rose. "In that 10 month-period in which the Fed tapered, not just talked about tapering, the S & P 500 gained 15.7%. All sizes, styles and sectors as well as 90% of the sub industries in the S & P 1500 were higher in price, and tech was the second best performing sector," said Stovall. What could go wrong? But while strategists expect the market to continue moving higher, there are things that could go wrong. Inflation is the biggest concern, since the Fed could change the timetable on the tapering and move towards interest rate hikes sooner than expected. Currently, the futures markets are pricing in a little over two rate hikes next year, starting with a full hike by July. There are about three more priced in for 2023. The Fed has stressed its move to taper the bond purchases does not automatically mean it will raise interest rates. On Wednesday, Fed officials retained their description of inflation as "transitory" or temporary in their statement, though inflation reports and wage data have all been hotter than expected for a longer period than anticipated. Fed Chairman Jerome Powell clarified that the Fed believes the issues causing inflation, like supply chain disruptions will fade, and that the Fed used the word "transitory" to indicate central bankers expect inflation will not be persistent. "The most important variable you're thinking about in the markets in the weeks and months ahead would be inflation," said Leo Grohowski, chief investment officer at BNY Mellon Wealth Management. Grohowski said the Fed's comments on "transitory" added an edge of uncertainty to its view that inflation would fade. "That makes the data even more important...It's really inflation and inflationary expectations that's really going to be the focus here particularly as we get through earnings," he said. "It makes us be on watch even more...It's not on autopilot, they are going to be data dependant," he said. Stovall said the issue for markets will ultimately be higher interest rates, though hotter inflation would be a warning on rates. "The Fed has transmitted tranquility through transparency," he said. Right now the market expects the Fed to gradually reduce the bond buying at a set pace. "Right now it's expected the Fed will taper in a straight line fashion, but what if the tapering, the timing or magnitude is accelerated? That would be a problem," he said. " "The real question is what's going to happen to interest rates. People buy stocks because of earnings. People value stocks based on intrinsic value. Interest rates are very important component of valuing a security so should interest rates rise and rise rapidly more than the market is anticipating, that could be a problem," said Stovall. Stovall expects stocks to rise into the end of the year and continue to rise next year. "The market could advance quite nicely through April, but should we start to worry that the Fed will need to pick up the pace for when they raise interest rates," that would be a concern for the market. He noted that there is disagreement over when the Fed will raise rates with some strategists predicting next year, and others not expecting a hike until early 2023. "Right now, the Fed is saying the economy is strong enough to handle tapering, then economic growth and earnings should likely increase along the way, as well, so there's no reason why stock prices cannot continue to appreciate," he said.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, October 19, 2021.

Brendan McDermid | Reuters