Investors: How to Profit by Understanding the Fed

Why have so many TV “experts” been so wrong about the market?

Many blame government. This demonstrates that they fail to include the government factor in their forecasts.

The recessionistas asserted that economic decline was inevitable. Investors were assaulted with negative stories. This included multiple TV appearances by the ECRI and weekly columns from Hussman and Mauldin and assorted “100% recession” forecasts. It went on for more than a year. The puppet shows about the “Bernank” went viral. Meanwhile, this video (via Bonddad) has only a few thousand views.

Truth is harder to sell than fear.

How to Profit

This is a wonderful opportunity for the average investor!

Why not make objective forecasts about government policy and the likely effects? Be agnostic about partisan politics. Try to profit no matter who is in power.

The pundits make a series of mistakes, which you can easily avoid:

  1. Underestimating government. Many have heard that George Soros “broke the pound” in his bet against the UK. Here is a clue. You are not George Soros! Governments are large and powerful and traders are small. A determined government policy will squash you like a bug. Beware.
  2. Oversimplifying. The story is that the Fed prints money and rushes out to buy Treasury debt. The CNBC anchors ask rhetorically how much higher interest rates would be if not for the Fed. They nod wisely at each other without bothering to provide any evidence. Here are two doses of reality.
    1. The entire QE program has less than a 1% effect on the ten-year note. QE3 is only a few basis points in terms of direct effect.
    2. There is no direct link from QE investments (think POMO) to purchases of soybeans, oil, stocks, or anything else. If you can’t trace the cash, don’t risk your stash!
  3. Poor forecasts. The average pundit thinks that the Fed may change course at any moment. The market overreacts to every dissenting speech by a Fed member. Meanwhile, the main message is clear: Expect aggressively easy money until the economy gets better. The Fed is trying to change expectations. That means you! Policy will not change because of a few strong economic reports.
  4. Too much politics. The entire monetary policy debate was politicized during the election campaign. The “out party” will always attack – Dems in 2008 and GOP last year – but investors should see through this.
  5. Overemphasis on stock market effects. The Fed is interested in the stock market as a measure of their effectiveness and as a (minor) economic transmission mechanism. From the Fed perspective, the more important measures are interest rates, employment, and GDP.

I do not want to turn this list into a slogan about fighting the Fed, since the story has more nuances. It is not just the Fed, but central banks around the world. And the interpretation of Fed policy cannot be done with a simplistic “risk on, risk off” approach.

Useful Background Reading

In preparing tonight’s post I was looking for something original to say. I started by reviewing my past work on Fed policy and the individual investor. Many of the key points are analyzed in more detail on my investor resource page about Fed policy and QE. You can easily find the links for the last few years and check my record.

If I had to pick a single recent post, it would be my discussion of QE3 misconceptions and how to profit.

While the market is about 6% higher in the four months since I wrote that post, it is not too late. This story has many, many months to run.

One specific theme is to play stocks that are earlier in the business cycle, like Caterpillar (CAT). I also continue to favor technology names like Oracle (ORCL) and Apple (AAPL).

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One comment

  • Andrew H February 27, 2013  

    I watched Bernanke’s testimony from a hotel room in Dubai. (I was very bored.) But I am sure I heard one committee member mention “The Hong Kong and Singapore Banking Corporation”. If that is the quality of panel member I am in fear!! There had also been no thought given to the possibility that the Fed might hold paper to maturity and assuming no domestic currency default (??) by the US there would be no capital loss. Climbing the wall of worry seems to be a little easier today than it was 12 months ago. Italy spooking the market lasted a very short time – it may and probably will come back but if I have learned nothing else from reading “A Dash” it is to take what the market gives you.