How Markets Misunderstand the Fed's 'Taper' Economy

Five sources of confusion for investors about the Fed’s latest move.


But those two factors don't point to an economy sliding back into a recession. Growth has been slow and steady. "Much of the economy has the potential to stand alone without extra stimulus," says Dickson, citing autos, health care and technology as areas that could perform well even without it.

Despite massive outflows from bond funds, not all forms of income are dangerous. Investors, meanwhile, have been bailing out of bond funds for months, and analysts have agreed that it's not a bad idea to limit exposure to long-term government debt. But there are ways investors can stay invested, even in income.

"Dividend growth stocks and short-duration bond ladders [bonds that mature at different time intervals from short to long] should provide average returns with modest risk," says Dickson, who adds, "This is not the right market climate to chase high-risk stocks or high-yield speculative bonds or leveraged bond funds."

[Read: Bond Bandwagon Leaves Fixed-Income King in the Dust.]

S&P Capital IQ's head of ETF and mutual fund research, Todd Rosenbluth, says he screened for funds made up of relatively short-duration bonds that may offer solid yields even when rates rise. Among the funds that fit the criteria were the Metropolitan West Total Return bond fund, Vanguard Intermediate-Term Investment-Grade fund, Guggenheim BulletShares 2016 High-Yield Corporate Bond ETF, iShares 3-7 Year Treasury bond ETF and the PIMCO Enhanced Short Maturity exchange-traded fund.

Listen to the Fed – it's not trying to mislead anyone. The Fed gave an unusually specific warning to investors in advance of its plan to cut back on its quantitative easing, and has been far more open in terms of communicating its plans with investors than in the past.

In a speech this week, the influential president of the Federal Reserve Bank of New York, William Dudley, gave more information on what the Fed is watching. The Fed, he says, needs to see "continued improvement in the labor market" before it stops tapering.

Unemployment has already dropped from the double-digit level of the recession to 7.3 percent in the latest monthly report, but that is still worse than any month in the 25 years prior to the financial crisis. Things are better than they were in the recession, but since then, "the economy has been recovering very gradually. Nothing has changed much," Dickson says.