“Artillery adds dignity to what would otherwise be a vulgar brawl.”
Frederick the Great
Policy Cannons, Fiscal Cliffs, and the Wall of Worry
With a thundering boom, the Federal Reserve announced a series of measures intended to prevent a slowdown in the US economy. Chairman Ben Bernanke has yet again fired what has been referred to in the financial media as the “big cannon:” large-scale stimulus measures, this time with no specific end date in sight.
It is another barrage in a series of previous bombardments that include curious names such as QE1, QE2, Operation Twist, etc. In a recent Congressional hearing featuring Federal Reserve Chairman Ben Bernanke, a notable Senator from New York spoke to the Chairman in an admiring tone, describing the Fed as “the only game in town” when it comes to attempting to fix the economy. And so it seems Congress remains shaking in the wings, each party too obstinate or indifferent to address the issues—especially with a Presidential election around the corner—and too entrenched to engage in another bitter fight that has become symbolic of our nation’s political environment. Criticize the Chairman as one might, but if Congress is unwilling or unable to engage in what might be perceived as a vulgar political brawl, then the Fed—some think—must try something with the tools at its disposal to offset the lack of solutions provided by Congress.
And so the American economy is left in large part to the devices of the Fed—aptly described by the Senator as the only game in town—to continue with a series of unprecedented stimulus measures aimed at resolving the stagnant recovery. Each of Bernanke’s announcements may be met with a thundering but potentially hackneyed boom. The announcements are thundering because of the sheer amount of dollars that are involved, and they are potentially hackneyed because one must wonder just how many times the same approach can be used without any adverse or unintended consequences. Prior to the most recent announcement, the Fed had already increased the US monetary base three hundred percent according to James Investment Research. Can this go on forever with the same effects? As the Fed purchases bonds on the open market with dollars that have been metaphorically “printed” for the purpose, the only consolation is that, like a teenager caught staying out too late, “all the other Central Banks are doing it!” And indeed, the world’s major central banks such as the European Central Bank and the Bank of Japan are. In fact, Central Banks have expanded their balance sheets by an unfathomable $10 trillion dollars.
The blasts from Bernanke’s large policy cannon have been targeted at a series of economic concerns that some in the media have termed a “Wall of Worry.” Chiefly among this wall, is a weak real estate market in the United States, a stagnant employment situation, a range of deteriorating economic data, a series of complex issues in Europe, and an array of measures that Congress must resolve shortly after the election. As the Wall of Worry stacked ever higher over the quarter, some investors counter-intuitively bought stocks in speculation that the Fed would be more likely to fire another salvo and drive financial asset prices higher through targeted bond purchases. Frequently over the quarter, bad news paradoxically caused markets to behave as if investors were reacting to good news.
Given the risks on the horizon, who would have predicted that the S&P 500, after taking dividends into consideration, would gain around 16% so far this year, and 28% over the past twelve months? The S&P 500 closed the quarter near its all-time high that was reached in October 2007! With the Wall of Worry towering above, does it really feel like the “good ol’ days,” economically speaking?
One of the larger issues in the United States is that of the so-called “Fiscal Cliff,” which refers to a series of tax increases and budget cuts that will go into place if left unaddressed. These increases include the expiration of Bush-era federal income tax reductions and the expiration of payroll tax cuts involving Social Security. The non-partisan Tax Policy Center estimates that 90% of families face unprecedented tax increases, with a $3,500 per year average tax increase for all households. Regardless of monetary stimulus from the Fed, the non-partisan Congressional Budget Office declared that a US recession is likely in 2013 if no resolution is reached, unemployment could reach 9%, and the gross domestic product (GDP) would contract over the next four quarters by about -0.5%. The immediate shock would be a hit to the economy given the abrupt increase in taxes combined with the sharp decrease in government spending, which—like it or not—constitutes a significant portion of GDP.
Do Not Fight the Fed?
Wall Street is rife with prosaic “truisms,” none of which are true 100% of the time. “Sell in May and go away!” “Buy low and sell high!” “The trend is your friend!” And perhaps somewhat-suited to the situation: “Don’t fight the Fed.” In the current environment, a couple of these maxims might suggest adding equity exposure. But these sayings can be like broken clocks that are right twice a day. The trick for investors is to possess the ability to know when to come back after going away in May, and knowing whether the trend is still indeed your friend, especially with the market nearing all-time highs. Corrections of around 20% or more occur relatively often (over the past 15 years, for about 36% of months, the S&P 500 has been “underwater” by -20% or more from a previous peak; and nearly 12% of rolling one year periods have been corrections of -20% or more). But still, at least three of these sayings held true in the third quarter given the pullback faced in May, and the continued rise that coincided with the Fed’s actions (and anticipation of the Fed’s actions). Is one really “buying low” with the S&P near all-time highs? Should one “fight the Fed?” Investing in a manner that contradicts the Fed’s actions has been a far less profitable strategy than doing the opposite. It can be uncomfortable staring down the barrel of a loaded Howitzer, especially if the artillery crew is fully staffed and ready to fire.
Even though markets are at their highs, and the Wall of Worry is stacked just as high as ever, it may not be a simple conclusion to avoid stocks entirely. Data released after the quarter’s end indicated an improvement in unemployment. During the quarter, the housing market showed signs of gaining footing as both existing home sales improved and housing starts improved. Some market commentators have pointed to three different types of buyers that helped drive the summer’s rise in stocks, which occurred on abnormally low volume. First, some bond investors have allocated portions of their fixed income portfolios to dividend-paying stocks in order to offset painfully low yields (we do not usually recommend doing this, since the purpose of fixed income is to provide stability, and equity investments are inherently volatile). Second, foreign investors have become more interested in US stocks, sometimes perceived to be a safe haven compared to less-stable foreign stocks. And third, there were several hedge funds caught off guard that were correctly out of the market during the May pullback. As the summer rally intensified, many of these funds jumped back into stocks in order to make up for lost exposure as the market changed direction.
For investors who have many years ahead, who would be able to tolerate a typical correction of 20% or more, there is a longer-term case for equities that begins to make sense. Wall of short-term worry aside, a long time horizon may allow investment managers to capitalize on some long-developing tailwinds.
Banks are showing signs of becoming substantially healthier, for starters. Leverage ratios for banks are at 20 year lows; and the initial signs are emerging that demand is returning to the housing market. Consumers have deleveraged to a significant degree, and many have stronger personal balance sheets. Those fortunate consumers who are fully-employed may be able to set the stage for an increase in demand. Corporate balance sheets have been strong relative to historical levels for a couple years now, and continue to stay strong. And the decision for US-based manufacturers to outsource to China is no longer a “slam-dunk” decision as tangible and intangible costs involved with manufacturing overseas have increased. It’s possible that manufacturing in the US may have changed from a downward-sloping trajectory to a flat-to-moderately upward sloping one. Recently, one of our money managers identified that the total value of the stock market when compared to the total value of the bond market is lower than it has been at any point over the past 40 years. If capital were to exit the bond markets and return to equity, capital flows alone could possibly drive continued performance in stocks.
For investors with long enough periods of time to invest, it may make sense to look past the Wall of Worry, while simultaneously understanding the potential short-term downside risks involved. With a long enough timeline, it will matter less what intervention the Federal Reserve is imposing, what might be happening in Europe over the short term, or what may have been the drivers behind the low volume rally of the summer. The market, however, is near levels first set before the financial crisis of 2008 after several very strong years of a continued upward run. If you have a time period of less than 7-10 years in which you plan on accessing capital in your portfolio or would not be able to withstand a 20% (or greater) correction, then we suggest seriously evaluating your appropriate level of exposure to stocks.
In the short-term, there are several notable risks in the global financial system, but the Federal Reserve is a powerful force intent on driving asset prices upward. In recent years, this has been a difficult force to contradict, but the Fed’s measures remain thoroughly untested, so systemic risk levels may be fairly high.
Although it may even take Congress several market cycles to get its act together, we believe that our elected representatives will eventually take meaningful action. In the words of Winston Churchill: “You can always count on Americans to do the right thing—after they’ve tried everything else.” In the event that you have any questions, or would like to revisit your portfolio’s allocation, we would welcome your call. In the meantime, we appreciate your business and wish you a pleasant fall.
Thank you for your business,
Heintzberger | Payne Advisors
September 30, 2012
Past performance is no guarantee of future results. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Opinions are subject to change without notice. Heintzberger | Payne Advisors ©2012