The Fed, the Economy, and Stocks
Sometimes a concept is so simple and compelling that one would expect it to be universally embraced. When important government agencies demonstrate a commitment to addressing a problem, investors and traders alike would be wise to take notice.
Instead, stocks have declined dramatically, actually beginning at the time the Fed engaged in cutting rates and initiating the successful TAF facility. A key point is that Wall Street guru’s and pundits all seem to believe that they are better and smarter than those in government.
At "A Dash" we try to find the real experts. There may be other blogs written by people who have extensive experience in the three relevant arenas – academia, government, and financial management — but we have not seen any. (Readers please correct us ASAP).
The choice for the investor is easy. On the one hand, you can accept the arguments of the market pundits who think that government officials are too stupid and academics are too smart, and both are therefore out of touch. Alternatively, you might consider the possibility that some very bright and capable people choose different career paths. They are all good at what they do.
Outsmarting the TV and Internet Experts
The unending hunger for content makes everyone an expert. Today the CNBC noontime anchors were swept away by a prediction of an inter-meeting rate cut by the Fed, a prediction made by a young woman who is a strategist for a firm trading fixed income instruments.
She might be correct in her call, but many of the bearish pundits have made two big mistakes:
- They predicted that the Fed was "in a box" and would not ease aggressively. Strike one.
- They next opined that the Fed must stop cutting rates because of a declining dollar and rising commodity prices, something that they accept as a better measure of "inflation." They were wrong again. Strike two.
These pundits now think that the Fed is "Pushing on a string." We hear this prediction from very few actual economists. This is pretty strange. We believe that it will be "Strike three."
At "A Dash" our view is that there are plenty of experts on different subjects. When we are looking for trading insight and stock-specific information, we read and consider carefully the views of Doug Kass (full disclosure — he is a colleague on TheStreet.com). His ideas are plentiful, profitable, and worth the price of admission. He endorses the "string" theory.
When it comes to economics, we prefer the viewpoint of David Malpass, who has had a multi-year record at reading the economic twists and turns with great accuracy. Last week he weighed in on this topic in a report for Bear Stearns investors, Massive Fed Power–How it Works.
Fed Not Pushing on a String
We think there’s a general underestimate of the power of central banks to stimulate their economies in the short term.
• U.S. recessions have occurred when the Fed tried to stop inflation with high interest rates (1974, 1980, 1982, 1990), a situation the Fed may put off until 2009 or 2010. In contrast, when the Fed has held interest rates down to the inflation rate or below, the result has been strong growth, as in 1977 and 2003.
Malpass goes on to explain how the effects are amplified by the Hong Kong Monetary authority, how circumstances have improved since the August credit problems, and why the economy is likely to expand. He does not believe that it will "end badly."
The compelling argument is that the Fed is determined to avoid a deflationary spiral. If you are an investor, that is something to keep in mind.
Will this result in some future inflation? It depends upon the reaction of the economy and the pace of the Fed in reversing the rate cuts. While no one knows for sure how this will play out, it is not a firm basis for investors and traders looking to the remainder of 2008. That story is one of economic expansion, including both the Fed and fiscal stimulus.
Some Analysis of Rate Cutting
Michael Zhuang at The Investment Scientist has a nice table summarizing stock returns after periods of Fed rate-cutting. His familiar conclusion is the quote from Marty Zweig, "Don’t Fight the Fed." Readers should check out his article for the full story.
We believe that the analysis actually understates the case. The current environment is even more bullish since we are starting from such a high level of negativity. Actual corporate earnings outside of financials remain strong. The financial stock earnings include write-downs that emphasize current FAS 157 accounting, marking to illiquid markets, rather than looking at future potential. It is something to consider.
Conclusion
Market averages are heavily influenced by technical trading, forced liquidations, and sentiment. As we indicated, there is a sense that January lows must survive a re-test. We are not anticipating a good employment number on Friday, a subject for tomorrow.
We do not indulge in short-term market calls. On somewhat longer basis, the averages are still trading at the level when our Gong Model (report available upon request) indicated a good risk/reward for those with a multi-month horizon.
We are also very confident that a solution for monoline insurer problems will be forthcoming. The market skepticism on this subject has been vastly overdone. This is an important development for financial stocks, particularly Merrill Lynch (MER).
Full Disclosure: We are long MER.
Demonizing those with different approaches appeals to the emotional centers in the prospective audience.
Remember when Clinton was elected and produced a budget plan with a tiny increase in taxes for the top income earners which the opposition claimed it would “wreck the economy.”
It didn’t, anyone who bought equities made out fabulously. Today the hatred of Hillary (Barack… Hussein.. Obama) and even McCain are getting folks into a lather.
These folks buy and sell based on their feelings. They’ve made decisions all their lives based on feelings. Why should investing be any different (and why not lever up into a bigger home, they always goes up, right?)
The anti-Bernanke rants find support in the deep anti-intellectual creation-theory-believin’ populace. Trying to change their thinking is a monumental undertaking. I salute your attempts.
http://www.reuters.com/article/businessNews/idUSWEN425620080303?feedType=nl&feedName=usdai&pageNumber=2&virtualBrandChannel=0
“At 1,300-plus on the S&P, stocks are not cheap,” Buffett said, referring to the Standard & Poor’s 500 index .SPX, which has fallen about 16 percent since mid-October.
“I find more things to look at now than I did six months or a year ago, but I would say it’s changed more dramatically in the fixed-income market than it has in the equity market,” he added. “That may be where I find the opportunities.”
Having watched the Buffett segment on Squawk Box the other day, I’ll add he also mentioned stocks were not very expensive either.
Again though, it is a market of stocks and not a stock market. There will always be attractive individual stocks that are undervalued regardless of the S&P 500.
Jeff,
All “experts” talk their own book. Bond commentators in particular are totally partisan in their opinions and the sense to which they are treated otherwise by the media is extraordinary. This is because they operate in a world where a key part of the price is set externally by the Fed – unlike commodities, FX or equities where it is set by the market. When did you ever hear a bond analyst tell you that it would be a good thing for the Fed to raise rates – unless he was already positioned – and recommending – a steepening trade? This, incidentally, explains why the market initially took the TAF measures so badly – it seemed to reduce the need to cut rates to extreme levels and limited the trading profits of those positioned for further rate cuts. Those of us with a view on the role of the Fed that extended beyond the bail out of our trading position viewed the Fed move very positively, but even when the wisdom of the move proved itself over the coming months, it continues to be damned with faint praise by those who would prefer Fed Funds to be at 1% by now for reasons that bear very little reference to what policy needs are and a lot to where trading positions continue to be. Comments on Fed policy are all about trying to railroad sentiment towards the Fed in order to get delivery on a position – normally on the Fed Funds futures which traders and investors price in relation to the centrally prescribed official level. If I am short FFF and the Fed cuts rates – happy days. Therefore I will find whatever arguments I can to gain support for another cut/rise in rates. The “strategist” is not opining on the real world impact of rates or the multiplier effect on asset prices – she is simply talking up the trading call of positioning for a lower Fed Funds rate – the intra meeting call helping to extend the value of the trade by shortening the time premium cost of the position.
Ultimately it is why bond analyst calls should only be greeted with extreme skepticism by an equity investor as the consequence of their “view” on equities is, to them, largely incidental. It’s high time the media stopped ascribing any sense of independence to the views of the bond investors in regard to the real economy or the actions and policies of the Fed.
I don’t doubt that Bernanke knows more about economics, and has better data, than I, and at least 99.99999% of market participants, do. He’s smart, well-educated, and serious. However, the economy is way too complex for any one person, or even a small group of people, to actually know very well. You can keep putting your faith in central planners/bankers, I’ll keep my empirically-backed confidence in the market as a whole. I won’t always come out ahead, but I usually will.
There are some very good comments here. I appreciate all who took the time and effort to make such thoughtful observations. It is especially helpful to get some commentary from those with a fixed income orientation.
As to Buffett’s opinion and Maestro’s comment on the wisdom of the market, I have a different approach. I respect both. The market tells you every day whether you were right — on that day. Buffett is a hero in my book.
Having said this, if one does not expect to do better than the averages, just buy an index fund. What I do is find themes where most market participants stubbornly follow people who lack the right expertise. When the market seems to confirm that viewpoint, they all congratulate each other. Sometimes they exit positions at the right time.
Over my ten-year history as a manager my themes have played out quite well in all kinds of markets. As you might expect, I did better than Buffett in the tech boom, since he avoids those stocks. He gains some ground back when value stocks come into play. Both of us enjoy a big lead over the S&P 500. My personal competition with a legendary investor is, of course, unknown to him, nor would he care. He would be more interested if I beat him at bridge!
Thanks again to all,
Jeff
There are no experts in this business.
I think I may have been too glib (yes, too glib, I was trying to be glib, just not that glib). I came off as a market efficiency true believer. Or, at least, that’s how I would have read my comment if I weren’t me.
What I meant was that I am generally price agnostic, i.e., market prices are basically right. I deviate from my agnosticism in specific situations, but agnosticism is the default position. I agree that we should plan for what the Fed is doing, instead of what we believe it should do (don’t fight the Fed). But then, find me one person who doesn’t think that. The corollary to that is that we should plan for what the Fed’s actions will cause, not what they intend for them to do. If the price of gold triples in 6 years, I view that as a very strong signal that inflation is coming. I don’t know enough to be able to say what precise course of action Bernanke should take, but i can still accurately judge his actions to be inadequate and/or wrong. So, yes, discount ignorant commentary from people just trying to make headlines and such, but that doesn’t mean that we shouldn’t worry because “the Fed is on the case.” Remember the old joke, “I’m from the government and I’m here to help.” My problem is not with Bernanke, it’s with the system in general.
Whether there are “experts” is an interesting question. My own view is that most “experts” have that status conferred on them by others (social proof concept) because of the credentials they hold. That doesn’t mean that experts cannot be very, very wrong about key issues.
Take the issue/question of the “housing bubble”. Hopefully, at this juncture, nobody seriously disputes there was in fact a housing bubble both in terms of housing prices in many regions of the country and excessive housing inventory being built.
Yet, take a look at Bernanke’s position on the “housing bubble” issue as early as a few years ago. From Jeremy Grantham’s Q407 letter:
The second Greenspan prize – for “incomprehensible
misreading of obvious data by an apparently well-informed source” – goes appropriately enough to Ben Bernanke for his late 2006 comment that, “U.S. housing prices merely
reflect a strong U.S. economy.”
I don’t know. I mean, cmon. Couldn’t anyone who looked at Shiller’s 100 year chart of housing price growth, and seen the 2-3 standard deviation up move over the past 5 years recognized that hey this sure does look like a bubble. But it seemed like many “experts” were coming up with all sorts of explanations why prices were justified.
Frankly, I think Bernanke may have recognized housing was a bubble but was reluctant to go on record saying it because of the consequences of him making such a statement, although the aftermath was probably was unavoidable at that point regardless of what he said.
One question/issue now would be if inflation is starting to head in the direction of being an issue, will Bernanke recognize/talk about it when you look at the record on the housing issue?
Maybe some experts do get it right?
“Too many bubbles have been going on too long.”
(Paul Volcker, January 2008)
Mike C: As you well know, anyone who goes on the record with a lot of speeches and Congressional testimony provides an extensive record to study. You and I could sift through this and find projections and opinions that seem really wrong in hindsight.
Anything that has already happened acquires a sense of inevitability, as I think you know.
This “gotcha” mentality where everyone gets to look for mistakes is not a good method for discovering experts. Anyone who engages in competition would realize this.
If my bridge partner misses an inference, is he no longer an expert? Brett Favre threw more interceptions than anyone in history. Was he not an expert? What about the tennis player who makes an unforced error?
This is no different from an investment analyst who sees a situation that has a good risk/reward, but it does not work out on a specific occasion. Or an economist who makes a forecast that turns out to be incorrect.
And whatever you think about the bubble, the extent of effects is a function of a lot of other concurrent factors.
Thanks for the provocative comments. I’ll have to consider a more complete article on defining experts. I have written a few things about how people have failed to identify imposters, like the Chinese and the Econ grad student. …
Jeff
“When it comes to economics, we prefer the viewpoint of David Malpass, who has had a multi-year record at reading the economic twists and turns with great accuracy.”
I don’t get it…Malpass COMPLETELY missed the current bloodletting, insisting that all the fundamental economic signals including nominal jobs growth, savings rate, real wage growth, etc. were misleading. It was egregious enough that I really suspect that he did so deliberately to serve his masters at Bear Stearns whose fortunes were intimately tied to the illusions he was promoting.
Morgan Stanley’s Roach was far more accurate, and wound up being posted to Asia for his prescience…..
Black —
I am very interested in the criteria you would use for judging economic predictions. Frankly, there is nothing in actual economic data that qualifies as “bloodletting.” We may get a severe recession, and then we will see some very high unemployment, etc.
But I value comments, especially from regular visitors like you. Roach was one of my favorite reads in the late 80’s. On what points do you think he has already been proven correct versus Malpass? How have they both done over the last five years or so?
Thanks!
Jeff