Thursday, November 4, 2010

Fighting the Fed

   The midterm elections and Fed announcement have come and gone almost exactly in line with market expectations. Despite some expected volatility, the markets to this point have taken the news in stride. Trends have continued with the dollar falling and prices in nearly everything else rising. As mentioned previously, I believe the real tests for the economy and markets are still to come, a view unchanged by a Republican house or an open-ended 8 months of quantitative easing.

  As many in the market have cautioned for a long time, it is unwise to fight the Fed. The premise is that given the Fed's ability to print an unlimited sum of dollars, any market which they choose to prop/bid up is in their realm of ability. Based on this notion, investors have raced into stocks and bonds, assuming the Bernanke "put" will prevail in the event of a deteriorating market. Although some bears may make the argument that eventually the Fed will unwind its balance sheet and raise interest rates, this day of "reckoning" may still be years off. For those with a short memory, it was only the summer of '09 when a budding recovery spurred expectations of significant job growth and rising rates by the fourth quarter of '09. As recently as this past spring, investors awaited word of exit strategies by the Fed and envisioned rising rates some six months out. Today, the Fed announced a new $600 billion in Treasury purchases lasting through the middle of next year and left open extending the program.

   Tucked away in the announcement by the Fed today was the view that inflation would remain below acceptable levels for some time. It seems reasonable to expect that the new program of quantitative easing was baked into this outlook for the future. In this light, the Fed's current actions seem a bit strange and leave some important questions unanswered. First, if the Fed doesn't believe $600 billion will be enough to significantly move the needle on inflation, why not start with a much larger sum? Second, if the Fed expects inflation to remain too low in eight months from now, is it unreasonable to assume an extension of QE2 or announcement of QE3? Drawing on this insight, let's presume that quantitative easing is extended and continues through the end of 2011. Previously the market expected that at least six months would pass after the Fed began selling assets before initially raising interest rates. Making a guess that the Fed will avoid shrinking its balance sheet for at least six months after they finish easing, the earliest possible Fed rate increase wouldn't be until some time in 2013.

   Using these expectations as a base case, one can understand why investors would assume they are in a "win-win" situation. If the Fed is wrong and the economy improves at a quicker pace, markets should surely strengthen. If the Fed is correct or the economy is worse than expected, the Fed may eventually drop money from helicopters, also sending markets higher. Although making money should be relatively easy given this premise, I feel inclined to offer a couple contrarian thoughts to the discussion.

   This morning on Bloomberg, an article referencing a Citigroup report highlighted the reaction of 10-year Treasury yields to the Fed's previous debt purchase announcements during the height of the financial crisis. Surprisingly, after the Fed first announced debt purchases in December 2008, yields rose from 2 percent to 3 percent in the following six weeks. In March 2009, the Fed announced it was increasing debt purchases and adding treasuries to the mix of purchases. Over the following couple months, yields again spiked from 2.5% to 4%. If history repeats itself with today's QE announcement, a wise investment may be to short longer term bonds for the next several weeks.

   An important counter to the previous point would be that yields have returned to much lower levels as inflation expectations waned. This certainly presents a risk to the previous trade, but it also implies that the Fed's ability to create inflation is limited at best. Although I'm not entirely convinced the Fed will achieve it's goal, failure would likely imply much more dire outcomes for stock and commodity markets over the next several years.

   One other potential crux of the recent bullish case, the topic of relative value. For several months now the media has been filled with investors arguing the relative value of stocks versus bonds as a primary reason to invest in the stock market. As an individual investor, I often have to remind myself that professional investors/advisors are paid to invest others money or offer guidance. Further, aside from those with long, strong track records, failure to beat their benchmark in a given year may result in a significant loss of capital. This is where the basic concept of relative value becomes so important. The fact that stocks may offer relatively better value than bonds (a point I agree with), only means stocks are expected to outperform bonds, not that they will certainly rise in value. In fact, it is entirely plausible that during some period of time both investments could show negative returns, but with stocks being slightly less negative than bonds. For the professional investor, the money generally has to be invested somewhere and therefore relative value is often solely important for allocating funds. However, for an individual investor, capital does not need to be fully invested or even mostly invested at all times. In fact, there are likely to be numerous times during the course of one's life where holding cash may prove to be the most valuable alternative. Therefore, one should not be swayed into buying stocks or bonds, solely on the belief it offers great value than the other. For those who believe a strong or large enough gap exists in relative value, buying the cheaper option and shorting the more expensive in a neutral position may be the best course of action.

Disclosure: Long Proshares Ultrashort 7-10 year Treasury (PST) and Proshares Ultrashort 20+ year Treasury (TBT).

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