DO Fight The Fed

Today, Wall Street's Professional Investor Class (PIC) waits with bated breath for the Fed to provide words of comfort so that one of Wall Street's revered axioms, "don't fight the Fed", will deliver much needed relief to the beleaguered warriors of finance.

One of characteristic of the PICs that is useful to remember is that they are highly reliant on heuristics - rules of thumb that help frame the world into bite-sized analytical pieces. One of the heuristics that has worked from time immemorial is 'don't fight the Fed". For example, last year, around this time, a well-known hedge fund manager advised investors and traders of this well-worn axiom to great effect and result (stocks rose from the fall of 2010 into the summer of 2011). Unfortunately, while the monetary elixir did work its magic on the PICs (they bought stocks), it had little effect on the real economy.

Never sated, the ever-thirsty PICs are back at the don't-fight-the-Fed troff for another hearty slurp of monetary ease = higher risk asset values. From the PICs and Fed's perspectives, the economic rationale for this view is rather simple: Easy money = an increase in the value of risky assets = a positive wealth effect = increase demand = higher GDP (which then = higher wages, increased hiring, etc, etc). Hence, don't fight the Fed ALWAYS delivers. Or does it? And when it does, is the effect always the same under all conditions? Or are the results a product of the economic and financial times?

It may be a risky thing to go against such a dogma. After all, the four most dangerous words in the investment language is "this time is different". And to assume that more easy money will not produce the above listed outcomes is the speak those very dangerous words. Yet, if one believes we are in times that are truly different, particularly in the post WW II era, then perhaps it's time from some fresh perspectives.

Going against such a well-established dogma of day is also especially dangerous given the changed structure of the market. For, when the momo lemmings (who could care less what the drivers are or what direction the markets are headed, just along as stock prices move) jump on the market trend du jour bandwagon, the wheels get turning rather quickly.

Investment Strategy Implications

If you are going to go against a revered heuristic it is useful to have your own heuristic to counter the revered one. My heuristic is this: in a liquidity trap, the effectiveness of monetary policy is limited, at best. Moreover, monetary ease becomes even more limited when fiscal policy is contradtionary (i.e., expansionary austerity). These global macro forces are strong, pervasive, and global in scope.

So, the PICs may rejoice in what they hear today. And risk assets may rise - for a while. But the global macro forces at work can, and I believe will, overwhelm the monetary elixir the Fed will provide. And the PICs don't do global macro very well. (More on this point in a future blog posting.)

Quotable Quotes

"You know Charlie Walser? Has the place east of Sanderson? Well you know how they used to slaughter beeves, hit 'em with a maul right here to stun 'em... and then up and slit their throats? Well here Charlie has one trussed up and all set to drain him and the beef comes to. It starts thrashing around, six hundred pounds of very pissed-off livestock if you'll pardon me... Charlie grabs his gun there to shoot the damn thing in the head but what with the swingin' and twistin' it's a glance-shot and ricochets around and comes back hits Charlie in the shoulder. You go see Charlie, he still can't reach up with his right hand for his hat...Point bein', even in the contest between man and steer the issue is not certain."
Ed Tom Bell
"No Country For Old Men"

"The Planning Fallacy"
David Brooks
NY Times, September 15, 2011

When the Nobel Prize-winning psychologist Daniel Kahneman was a young man, he led a committee to write a new part of the curriculum for Israeli high schools. The committee worked for a year, and Kahneman asked his colleagues how long they thought the rest of the project would take. Their estimates were around two years.

Kahneman then asked the most experienced among them how long such work took other curriculum committees. The gentleman pointed out that roughly 40 percent of the committees never finished their work at all.

But what about those that did finish? The gentleman reported that he had never seen a committee finish in less than seven years and never in more than 10.

This was bad news. They might fail to finish a task that they thought would be done in three years. At best, the project might consume eight or nine years. Yet this information didn’t affect those on the team at all. They carried on, assuming that though others might fail or dally, surely they wouldn’t.

As it turned out, their project took eight years to finish. By the time it was done, the Ministry of Education had lost interest, and the curriculum was never used.

In his forthcoming book, “Thinking, Fast and Slow” (I’ll write more about it in a couple of weeks), Kahneman calls this the planning fallacy. Most people overrate their own abilities and exaggerate their capacity to shape the future. That’s fine. Optimistic people rise in this world. The problem comes when these optimists don’t look at themselves objectively from the outside.

The planning fallacy is failing to think realistically about where you fit in the distribution of people like you. As Kahneman puts it, “People who have information about an individual case rarely feel the need to know the statistics of the class to which the case belongs.”

Over the past three years, the United States has been committing the planning fallacy on stilts. The world economy has been slammed by a financial crisis. Countries that are afflicted with these crises typically experience several years of high unemployment. They go deep into debt to end the stagnation, but the turnaround takes a while.

This historical pattern has been universally acknowledged and universally ignored. Instead, leaders in both parties have clung to the analogy that the economy is like a sick patient who can be healed by the right treatment.

The Democrats, besotted by the myth that the New Deal ended the Great Depression, have consistently overestimated their ability to turn the economy around. They regard the Greek crackup as a freakish, unlucky break, even though this sort of thing is a typical feature of a financial crisis.

Republicans, who should know better, also have an inflated sense of the power of government. In the presidential debates, Rick Perry, Mitt Romney and Jon Huntsman argue about which one oversaw the most job creation during his term as governor, as if governors have an immediate and definable impact on employers’ hiring decisions.

The reality, of course, is that the economy is not a patient. It is a zillion, zillion interactions. Government is not a doctor. Most of the time, it is a clashing collective enterprise that is occasionally able to produce marginal change, for good and for ill.

Democrats should be learning about the limits of social policy. As in the war on poverty, as in the effort to transform American schools, as in the effort to create prosperity in the developing world, it is really hard to turn around complex systems.

Republicans should be reflecting on the fact that if a Republican president were in office right now, and even if he or she did sensible things, the economy would still be in the dumps. It would be Republicans losing “safe” Congressional seats in special elections.

The key to wisdom in these circumstances is to make the distinction between discrete good and systemic good. When you are in the grip of a big, complex mess, you have the power to do discrete good but probably not systemic good.

When you are the president in a financial crisis, you have the power to pave roads and hire teachers. That will reduce the suffering of real people who would otherwise be jobless. You have the power to streamline regulations and reduce tax burdens. That will induce a bit more hiring and activity. These are real contributions.

But you don’t have the power to transform the whole situation. Your discrete goods might contribute to an overall turnaround, but that turnaround will be beyond your comprehension and control.

Over the past decades, Americans have developed an absurd view of the power of government. Many voters seem to think that government has the power to protect them from the consequences of their sins. Then they get angry and cynical when it turns out that it can’t."

Note: emphasis added

Nothing To Hang Your Bullish Hat On

Following on yesterday's market intelligence (what I believe quality technical analysis actually is) posting, a longer term view of the market reveals the erosion in strength that took place this past spring when the market made new highs. The accompanying chart illustrates this quite clearly: non confirmation from all three price momentum related indicators. This helped set the stage for the subsequent and current decline.

To be clear, as noted on numerous prior occasions the absence of external divergences (use search function for prior blog postings) + the modest (not over) valuation levels for stocks + the manner in which the bear got started (from bull to bear rapidly and not in rollover fashion) = a delayed recognition by yours truly to the current bear market conclusion. As Lord Keynes once said, "when circumstances change, I change my views. What do you do Sir?”

Going forward, a look back at the chart shows no signs of strength from MACD. This is perhaps the most reliable of the three indicators in confirming market direction. As is plainly shown, the crossover to the downside is solidly in place with no positive (bullish) crossover in the offing. Until that occurs (and it will, eventually), investors are advised to assume that the current rally is highly suspect.

Somebody Is Going To Be Real Right...

...and somebody is going to be real wrong.

If you have not heard from your friendly technical analyst, maybe it's time to find someone else in that field.

In what can only be described as coming straight out of the Edwards and Magee technical analysis bible (“Technical Analysis of Stock Trends”), the accompanying chart is a classic example of not one but two technical analysis chart pattern icons: Head and shoulders top and a bearish pole and flag.

This plus the fact that nearly 90% of the global indices I track are flashing bearish Mega Trends (use the search function on the top left for prior blog postings explaining this tool) is about as bearish as one can get.*

The first wave of a bear market almost always looks like a correction. Bulls will argue convincingly that key metrics like earnings and interest rates support this view. However, the anchor for this argument - solid earnings - can be easily undermined should the global macro story develop into something far worse than the bulls currently envision. For a recent example of this, just look at what happened from 2006 (S&P 500 operating earnings at a record $87) to 2007 ($82) to 2008 ($49). In this regard, the MERI (use search function again) is practically screaming earnings disappointments beginning next month. That could start the chain reaction of doubt, which is a strong characteristic of the second wave of the bear (as price crashes below the previous lows).

For a market priced for an economic muddle through, the worse case scenario is yet to be realized. Moreover, with limited flexibility to provide meaningful counter cycle actions, governments will be in no position to act effectively. Then there is the self fulfilling aspect of the negative wealth effect on the global macro environment that declining equity values tend to produce, which will almost certainly accelerate the downward pressure on the global economy (and earnings). Lastly, there is the unknown. Can anyone say with absolute certainty that all is good in China?

There's more. But suffice to say, an uncertain environment is hardly the prudent time to be fully invested.

Investment Strategy Implications

The advisable strategy appears to be to move as close to the exit door as possible. In portfolio strategy terms that means

1 - Reduce the equity exposure to a safe level, which for accounts managed and advised by Blue Marble Research is 60%. This means fade (sell) the rallies to, at least, maintain a constant percent equity exposure, but to preferably reduce down to the close-to-the-exit door level.
2 - Shift assets holdings to high quality dividend paying stocks.
3 - Be prepared to reduce the equity exposure to below 50% once the second wave gets underway. This means sell into the declines. The first wave of the bear gives you ample opportunity to sell the rallies. ("Looks like a correction to me.") The second and third waves do not.

Like I said, somebody is going to be real right and somebody is going to be real wrong. Of all things so uncertain in these times, one thing I am certain of: we will find out soon enough.

*Previous blog postings describe the unusual nature as to how we entered the bear (use search function). But the past several weeks have made it all the more traditional.

At Least The View Is Lovely

Stocks on the move today. Here's a picture that captures the moment.

Stocks Are Cheap

...and that's exactly the point.

More and more I hear the phrase "stocks are cheap".

In a market dominated by institutional investors, why isn't the "smart money" (as they are fancifully called) buying the obviously cheap goods up for sale? Is it because cheap is about to get even cheaper once earnings season rolls around? Or is it just another case of the momo lemmings (a/k/a momentum driven fast money hedge funds and HFTs) following the price trend du jour?

The accompanying table* is the Capital IQ consensus numbers for each quarter for this and next year. Applying the forecasts to the current price of the S&P 500, the P/E ratio for year end 2012 (just 16 months away) sits at 10.27 times projected earnings and at 11.40 times next year's projected price (increased by 11%, the long term average return for large cap stocks). To put this in perspective, these are numbers that are well below the recent historical average P/E of 15.

With the 10 year US Treasury rate below 2% and corporate profits projected to grow at a fairly nice clip, what's stopping the "smart money" from stepping up to the plate?

*click image to enlarge

Quotable Quotes: Richard Koo and Martin Wolf

Today, I am reinstating a popular blog service that I provided several years ago: Quotable Quotes.

In the past, I would seek out interesting and often humorous quotes from the very well known to those of lesser fame. In this updated version, I will include comments and other relevant data that are appropriate to the current economic, political, and market times.

The first installment (below) begins with a letter sent to and published in The Economist from noted economist Richard Koo. The emphasis (bold and italics) is added by me to accentuate key points that struck me as especially useful in understanding key elements in the investment decision-making process.

The second is an excerpt from Martin Wolf's most recent economic commentary. I encourage all to read his complete commentary (link provided, FT subscription required).

I trust you will find this reading well worth your time.

August 20, 2011

A different kind of crisis

SIR – The title of your leader on the debt crisis was well chosen (“Turning Japanese”, July 30th), but you missed the point. The Japanese problem of the past 20 years, together with the American and European problems of today, boils down to one fact: the economics profession has never considered a recession that could be caused by the private sector minimizing debt in order to repair balance sheets after a debt-financed bubble in asset prices. As a result, the profession has no clue as to what is the right thing to do.

In this rare type of recession, monetary policy is useless because people with negative equity will not borrow, no matter what the interest rate. Nor will there be many lenders when banks have such huge problems with their balance sheets.

In this environment, therefore, government must borrow and spend the savings generated by the deleveraging in the private sector in order to keep the economy from entering a deflationary spiral. But as John Maynard Keynes noted, it is almost impossible to maintain fiscal stimulus in a democracy during peacetime. It is this difficulty that prolongs this type of recession; it took Japan ten years to climb out of the policy mistake of premature fiscal consolidation in 1997.

The drama in Washington and other capitals is almost the exact replay of that confused policy debate in Japan. And the drama will continue until the public realizes that this is a different disease requiring different treatment.

Richard Koo

Chief economist

Nomura Research Institute

Tokyo

August 30, 2011

Struggling with a great contraction

Mr Obama wishes to be president of a country that does not exist. In his fantasy US, politicians bury differences in bipartisan harmony. In fact, he faces an opposition that would prefer their country to fail than their president to succeed. Ms Merkel, similarly, seeks a non-existent middle way between the German desire for its partners to abide by its disciplines and their inability to do any such thing.

Martin Wolf
Chief economics commentator
Financial Times

Media Appearances today

The time and segments are as follows:

Foxbusiness.com at 1 PM (eastern)

http://www.bloomberg.com/radio/ around 3 PM (eastern)

Prospective talking points:

1 - Overly optimistic earnings expectations by bottom-up analysts. A rude awakening awaits when 3Q11 earnings season gets underway. My proprietary MERI sits at -11.

2 - How the current bear market got started in an extremely rare fashion and why, for most investors, the current market rally will be so hard to sell into.

3 - My recent 10 day trip to Brazil. Impressions on the country and questions as why the US does not have a stronger presence there.