QE Taper Talk and the Stock Market

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Investors next week will be waiting for one key piece of info from U.S. Federal Reserve Chairman Ben Bernanke and the Federal Open Market Committee (FOMC) meeting: Will the QE taper begin?

It's been exactly one year since the Fed announced QE3 - also dubbed QE Infinity, with no clear idea of an end date given at the onset. The Dow Jones Industrial Average has climbed 14.9% in that time, and the S&P 500 is up 17.25%. Since the first round of this last series of quantitative easing started in December 2008, the indexes are up about 73% and 92%, respectively. The fear now is that if the Fed stops buying and rates begin to move higher in the months ahead, money will leave the market as quickly as it piled in and cause a prolonged selloff that drives down share prices.

Fed officials have been dropping broad hints that tapering is coming sooner rather than later.

While the Fed may initiate a QE taper at a gradual rate - reducing the $85 billion a month in bond buying by $10 billion per month - investors should expect a wild market reaction no matter how small the reduction is.

Even with a soft jobs number for August - non-farm payrolls were up a less-than-expected 169,000 - it's possible the Fed is ready to slow things down - but not fully take its foot off the gas.

"The Fed is under increasing pressure to taper without destroying the financial markets; this number wasn't soft enough to remove the possibility of a 'test-taper' this fall," Money Morning Chief Investment Strategist Keith Fitz-Gerald said last week. "Whether the taper is $10 or $10 billion doesn't matter. The markets are going to have a 'taper-tantrum.'"

Could the market decline on a QE taper announcement? Of course. Could it shake off concerns for a few more months and spike another 10% by year end? Indeed.

What we do know is that if you take a long-term view of markets, own reasonably priced securities, and hold insurance, you can make the increased volatility work for you.

So what should investors look to do ahead of any QE taper tantrum in the works?

Don't Fear a QE Taper and the Market Reaction

There have been many instances in market history of widely anticipated bad news leading not to crashes or declines but rip-your-face-off rallies that crushed traders who shorted stocks anticipating a negative reaction. Trying to position ahead by throwing all your money to one side of the market is a way to incur significant losses.

The best way to prepare for QE tapering is to use some common sense.

Review your portfolio for stocks that would be susceptible to large losses in a decline. If you have been playing the "pass the burning match" game of trading high-momentum stocks with high PEs like LinkedIn Corp. (NYSE: LNKD), Tesla Motors Inc. (Nasdaq: TSLA), and Boston Beer Co. Inc. (NYSE: SAM), you are exposed to a vulnerable market segment. Instead of these companies, you'll want to hold ones you are willing to bet on long term and would consider buying more of at 20% or 30% lower than the current price.

Also beware of investments tied to interest rates - especially these that our Global Investing & Income Strategist Robert Hsu issued a "Strong Sell" warning on...

If you are seriously concerned, consider puts on the S&P 500 ETF Trust (NYSE Arca: SPY). It would cost you about 3.5% to protect your portfolio. If the market does fall out of bed on tapering news, the puts will appreciate in value to offset losses in your portfolio. If it does not decline sharply, the options will expire worthless like other forms of insurance.

Another insurance move to make on a QE taper tantrum is inverse exchange-traded funds (ETFs). As Money Morning readers learned last month, there are plenty to choose from - go here for a rundown.

Finally, if you want to ensure portfolio protection ahead of a QE taper, check out "Four Ways to Sleep at Night" by Money Morning's Fitz-Gerald. Every investor should read it if they haven't already.