Market Commentary for 9.25.13
Proactive vs. Reactive
As an investor, you can choose to be either proactive or reactive. “Proactive” sounds so much better. It suggests getting ahead of the market and capturing a large share of the gains. Conversely, “reactive” has a poor connotation. You think of it as being late and capturing little or none of the trend. In truth it is always very difficult to know where the market is going. Over the past several years, there have been many points at which the market seemed to be faltering and a meaningful decline appeared imminent. The Greek debt crisis, the sequester, and the Syrian Crisis were just a few. Additionally, many investors believed the whole post-2008 rally to be built on a shaky foundation of Federal Reserve induced liquidity and therefore extremely tenuous. Indeed, how could the stock market have gained 130% from its lows while the economy continued to struggle? It was all a house of cards, the argument went, and smart money was on the sideline.
Maybe it will turn out to have been a house of cards. But if you have sat out any part of the past few years, you are probably not feeling like the smart money. U.S. stocks have climbed a wall of worry over the past several years, and the urge to be proactive – to get out before the market tanks – has only subtracted from investment returns. There have been numerous bearish baton twirlers making very sensible arguments the entire time – John Hussman, John Mauldin, Grant Williams to name three – but the marching band did not follow. So with all due respect to the laudable goal of being proactive, I’m not sure in most cases it pays in the investment world.
Benjamin Graham said the market is ultimately a weighing machine. To his way of thinking, the proactive investor could theoretically reap a profit by comparing the estimated value of an asset against the current market price. Today the Federal Reserve has its finger on the weighing machine. By purchasing treasury and mortgage bonds, it lifts bond prices. This in turn lowers bond yields and therefore the discount rate of future corporate earnings. By doing so, the Fed raises the value of stocks and thereby increases the wealth effect. So the question of when the Fed starts tapering and by how much is critical for stocks as well as bonds. Ben Hunt, writer of the blog epsilontheory.com, has a very good piece on the Federal Reserve and the questions of ambiguity (Greenspan) versus transparency (Bernanke):
“If you thought it was fun to have the Fed at the center of every possible investment decision made by every possible market participant, well, today was a good day. If you’re a tad weary of a Fed-centric universe, then not so much. It’s hard to believe that the global mania with Fed policy could possibly become MORE acute, but that’s what’s going to happen between now and the next FOMC meeting at the end of October.
The difference between doing nothing and some taper-lite $10 billion cut on purchases is minimal from a policy perspective. But it’s HUGE from a signaling perspective. It’s an intentional communication to inject ambiguity into expectations around Fed plans and walk back the linkages and language that had created a pretty strong Common Knowledge around Fed policy over the past 3 months. …for now I’ll just say this: Intentional ambiguity can be a very effective game-playing stabilizer, as can intentional clarity or linkages to external factors. But swinging back and forth between ambiguity and clarity is very de-stabilizing. This is a different concept from “credibility”, which is a phrase that gets tossed around a lot but I don’t think applies much here one way or another.
De-stabilization in today’s market context means higher correlations and greater Risk-On/Risk-Off behavior. Asset prices will go up or down in lock-step, with little or nothing to do with fundamentals and everything to do with the Fed. Wheeee!”
Another way of putting this is that as long as the Federal Reserve is taking a big role in the asset markets, market participants are concerned with positioning (as opposed to investing). The Fed says taper and we sell bonds and stocks. The Fed says no taper and we buy. Front-running the Fed has not paid off because the Fed may not do what it told us it would. In other words, the Fed is the big stack at the poker table, so while calling their bluff might work out in the long run, you are going to have to risk a lot of chips. If you believe the economy is not as strong as the market thinks such that stocks are overvalued, theoretically you would sell short. Do you want to risk that when the Fed just might respond to a poor economic report by launching a new liquidity program? For most market participants, the reward isn’t worth the risk. So we are all reactive now. And the worst part is, we don’t really know what the fair market (Fed-free) yield of the bond market is or the fair value of the stock market is, so we don’t really know how much more than fair value we are paying. My concern is that the market will come to the conclusion that the Federal Reserve is not going to be able (or willing) to taper for a very long time. The logical extension of that thought is that profit margins and prices are artificially high, such that P/E ratios need to fall in order to compensate for the distortion. That is what the market did in the 1970s to adjust for the fact that a large share of earnings gains were due to inflation.
Uncertainty over what the Fed is going to do and how the market would react to a permanently active Fed is almost certain to result in continued periodic bouts of volatility. Investors and advisors need to be prepared.
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