How to Profit From the Fed-Induced Sell-off

The markets have reeled in reaction to news that the Federal Reserve intends to end its $85 billion-a-month bond-buying program by the middle of next year.

Let’s take a look at why this is happening and how you should play it now.

For the past several years, Fed Chairman Ben Bernanke has helped goose the economy (and stock and bond markets) by keeping short-term rates near zero and – through the Fed’s bond-buying program – long-term rates artificially low.

Lower rates have punished savers, of course. But they make it easier for corporations and the U.S. government to borrow, and cheaper for consumers to spend.

Higher stock and bond prices also created a “wealth effect” that helps mend the damaged psyches of investors hurt during the recent financial crisis and improved consumer confidence.

This artificial stimulus was never meant to last forever. Yet – like a strung-out junkie – U.S. markets convulsed when told their narcotic of choice was about to be taken away.

Signs of Improvement

Despite the short-term pain, the Fed’s move is a good thing in two ways. First, it signals that the Fed sees U.S. economic growth improving enough over the next several quarters to remove emergency measures. You wouldn’t be alarmed if your doctor recommended removing your I.V. – and you shouldn’t be spooked by news that the economy is healing either.

Yes, yes, we all know that the Fed can’t really predict how the economy will perform in the future. But recall that Bernanke is only removing the stimulus because conditions warrant it.

If we start to backslide you can expect to see QE4 (or the resumption of QE3). These measures too, of course, will be merely temporary.

Move Cautiously

The second good thing is that the sell-off has created some interesting opportunities. Bargain shoppers have the chance to grab some great values.

However, when it comes to taking advantage of those bargains, I would use two different approaches for stock and bond markets.

In my view, it is still too early to commit to bonds in a big way, especially long-term investment-grade bonds and the junkier junk bonds and prime-rate funds. And leveraged closed-end bond funds – where I’ve sounded the alarm for months – are still too toxic to touch. So, as the Oxford Club’s Bond Strategist Steve McDonald says, keep any bond purchases high quality and short-term.

As for stocks, you know the drill. Corrections always present investors with new opportunities.

But, at least for now, you should concentrate on industries that are less interest-rate sensitive since their prospects are least diminished by rising rates. Energy and technology are two particularly attractive sectors right now.

Also, proceed with caution in the stock market. To take advantage of a crisis – or a correction – you don’t have to be the first one to the fire. Put money to work but don’t overdo it.

History shows that corrections generally take a few weeks to play out. So keep some of your powder dry and buy only those special situations where you feel you will lose out if you move too slowly.

In sum, the gradual removal of the Fed’s economic stimulus should not have come as a great surprise and is positive in many ways. Yet the indiscriminate market sell-off has taken down many great companies along with their weaker sisters.

My advice? Let the weak sisters tumble. But start putting fresh money to work in high-quality companies with promising prospects, growing market share and sustainable profit margins.

If history is any guide, six months from now you’ll be glad you did.