28 Feb 2014 Don’t Fight The Fed
One of Wall Street’s wisest admonishments is to avoid positioning one’s investments contrary to Fed guidance or actions. After all, they are the only buyer or seller in the US with an unlimited supply of money for their purposes. Since the Great Recession our Federal Reserve has been bent and determined to stimulate employment, with few references to the inflation it might cause. In fact, they have been far more concerned with deflation than with the threat of too much money driving up prices.
When the Fed speaks, markets move and the last 12 months serves as a powerful example of the point. The total US stock market, as measured by Vanguard’s Total Market ETF, is up 23.2%. Stock growth however is in stark contrast to a stubbornly slow economy bumping along at little more than 2% growth. We just learned that fourth quarter GDP was revised down to 2.4% from an earlier estimate of 3.2%. The Fed’s new Chairwoman Janet Yellen told Congress yesterday that the slowdown might be the result of bad weather.
Just how powerful have Fed comments been on market movements in the past year? The four market drops you see below range from 3.7% to 8%. Each one of them is primarily related to comments made by then Fed chairman Ben Bernanke about his continuing strategy to stimulate the economy, known as monetary policy.
1. Judy Shelton of the WSJ on May 23, 2013 said “Since Federal Reserve Chairman Ben Bernanke testified before Congress’s Joint Economic Committee Wednesday morning, commenting on the economic outlook and responding to questions from lawmakers on the likely path of monetary policy, financial markets have experienced turmoil. Triple-digit gains in the Dow Jones Industrial Average turned negative later that afternoon. That spurred a 7.3% plunge in the Japanese stock market, which in turn dragged down bourses in Frankfurt, London, Paris and Rome on Thursday morning—sending U.S. stocks on a roller-coaster ride. Mr. Bernanke must be thinking: ‘Was it something I said?’
We should be asking ourselves a different question: Does it make sense for financial and economic outcomes to be so highly dependent on the pronouncements of a single individual? Would it be better if monetary policy were more rules-based and less discretionary?”
2. “The big news hurting stocks was a seemingly positive report: New weekly unemployment claims were the lowest since 2007, the latest in a series of indications the job market is improving. But that reinforced fears that the Fed will decide as soon as September that the economy is strong enough for it to begin reducing its $85 billion in monthly bond purchases designed to stimulate the economy.” WSJ August 15, 2013
3. WSJ Review & Outlook Sept. 18, 2013: :Did we miss Janet Yellen’s nomination to be the next Federal Reserve chairman? We could swear that was still Chairman Ben Bernanke answering questions Wednesday at his quarterly press conference, but the Fed’s decision to renege on beginning to taper its bond purchases [Quantitative Easing 3] sounds like Vice Chair Yellen, the famous monetary dove, may already be in charge. That is at least as logical an explanation as the two reasons that Mr. Bernanke offered Wednesday for the Fed’s surprising policy blink. The Fed chief cited the dangers of recent market “tightening” in the form of higher long-term interest rates, as well as the risks of fiscal “drag” from Congress.”
4. “Despite disappointing December jobs data, the U.S. Federal Reserve remains on track to continue the steady withdrawal of its extraordinary stimulus measures later
this month. The Fed is on course to reduce its current $75 billion-a-month bond purchases by another $10 billion after its meeting on Jan. 28-29—Chairman Ben Bernanke’s last at the helm. The central bank must also figure out how to best describe its plans for low interest rates—the other prong of its strategy to boost the economy. While officials are in no rush to raise rates, we note that a miscommunication could roil markets and undermine the Fed’s credibility.” Gerard Baker, Editor in Chief of The Wall Street Journal
With Janet Yellen now in place as the new Chair of the Fed, markets are watching and listening closely to learn her style of communicating the Fed’s policy ahead. The latest reduction in GDP has some wondering if the Fed will stick with its current reduction of monthly bond purchases by $10 billion to $65 billion as they indicated in their January meeting. They expected then to continue winding down the program by year-end, barring an unexpected slowdown in the economy.
It could be that 2014 will be the last year the economy will need the Fed’s training wheels. Fed economists forecast the economy will grow between 2.8% and 3.2% this year, while the unemployment rate is expected to be between 6.3% and 6.6% at year’s end.
S&P 500 Index companies are exceeding analysts’ sales forecasts by the most since 2012, a sign rising consumer demand is fueling economic growth as the bull market approaches its sixth year, according to Bloomberg. Led by banks, utilities and drugmakers, sales beat analyst predictions by 1.2% this earnings season, the highest margin in almost two years, according to data compiled by Bloomberg.
While it’s tempting to look at the stock market today and feel it is over-valued after a 27% rise from their last peak on October of 2007, but that translates to only a 3.2% annual return. The long term (85-year) average return for stocks is over 12%. It may just be that all the extra Fed money sloshing around in the economy is finally gaining some traction in terms of spending, corporate earnings and economic growth.
Regardless, we encourage you to invest long term money with a long-term view trying not to worry about short term swings that are inevitable. We continually stress test your plans using our Monte Carlo analysis to ensure confidence that your important spending plans will not be derailed by misbehaving markets.
Its also expected that the unusual policy of Fed buying of billions of US Treasuries and Mortgage bonds is winding down. Perhaps by the end of the year the extraordinary valuation impact on Treasury prices will have ended and we will return to a more normal order of short-term interest rates supplying the Fed’s sole policy instruments. It won’t mean stocks will be any less volatile, but it will almost certainly mean (if history is our guide) that the Treasuries in our portfolio allocations will provide significantly better protection against stock volatility than they have in the past year.