Advice To Investors That 'Don't Fight The Fed'

by: John M. Mason

In attempting to defend the Federal Reserve's move to "taper" their purchases of $85 billion of securities every month, a Federal Reserve official used an analogy related to driving a car. The analogy goes something like this: The purchases of $85 billion in securities a month is like a person driving a car very fast. "Tapering" the purchases is like the driver of the car modestly slowing down the speed at which the car is traveling.

I would like to expand this analogy slightly. Investors have been told that it is not wise to "fight the Fed." That is, one can profit from the actions of the Federal Reserve by going with what the Fed is trying to do in the market and not invest in a way that is contrary to where the Fed is heading.

To me, this means that if the Federal Reserve is driving the car down a highway at 100 miles an hour then "smart" investors are driving their car down the highway closely behind the Fed's car and the investors are also traveling at 100 miles an hour. What happens, then, when the Fed eases up on the pedal, say to drive on at 90 miles an hour? Unless the investors take their foot off their pedal immediately, the investor's car plows into the car in front of it. The injuries can be quite severe.

All kinds of stories can be built around these ideas. Why should the investors travel so fast, so close to the car in front of theirs?

To switch analogies a bit, we can recall the one used by Charles (Chuck) Prince, former Chairman and Chief Executive Officer of Citigroup (NYSE:C), who famously stated in July of 2007: When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."

In other words, if the car in front of you slows down from 100 miles an hour to 90 miles an hour, "things will be complicated." However, as long as the car in front of you is driving at 100 miles an hour "you've got to get up" and drive 100 miles an hour!

Over the past several years, Mr. Bernanke and the Federal Reserve have made massive attempts to get financial markets to understand them and their innovations to monetary policy. They have even gone so far as to provide markets with "forward guidance" as to what they see coming on in the future of the economy. In addition, Mr. Bernanke and the Federal Reserve are specifying the relevant economic variables that will dictate what they do in the future. This, by the way, is called "contingent threshold guidance."

John Plender, in his article in the Financial Times, "Central Banks Risk Sharing Too Much With Investors" argues that this can be "unhelpful." He states, "Market expectations of the central banks are pitched too high. And because markets are so fragile there is a risk that central bankers are over-communicating policy, all of which leads to excessive gyrations whenever a policy maker hazards an anodyne statement."

Continuing, Plender states "In fairness, it is very difficult to communicate forward guidance, which is why so many statements in both the U.S. and Europe have been botched." Nevertheless, this is the environment we seem to be working in.

But, if investors are going to play the game of "follow the Fed" then they have got to be very nimble. If the Fed changes direction, then the investor must follow suit -- as rapidly as possible. This, of course, is the advice that investors must follow if they don't want to fight the Fed. Maybe some people -- some hedge funds -- have found this out!

Sam Jones writes about the "Return of the Blueblood Macro Hedge Funds" in the Financial Times.

"It used to be said that you could get on in the world of macro trading - betting on the ups and downs of the global economy - by following two simple rules: the trend is your friend and don't fight the Fed.

As if to underscore the point, the world's best macro traders - caught in a seesawing, profit eroding 'risk-on, risk-off' environment - have been battered by the slings and arrows of bond market gyrations and ECB intervention. They have foundered.

This year, though, has seen the impasse broken: the macro hedge fund manager, the blueblood of the investing world, is back."

The essence of the change -- the trend is NOT your friend. You must be flexible and nimble in your investments and be able to respond quickly to the actions of the Fed and other central bankers, like the central bank of Japan. The Jones article carries several stories about how the elite, blueblood hedge funds have adapted.

This, however, returns us to what Plender is talking about. Greater volatility in the financial markets. He argues, "So selling begets selling. The result is an extreme over-amplification of marginal changes in U.S. monetary policy."

Money can be made, and lots of it, by not fighting the Fed. But, one has to always be "on top" of what the Fed is doing and move rapidly when the Fed signals that the speed at which they are driving their car is changing or is about to change. Unfortunately, about the only people that can play this game are the "bluebloods." The other 90 percent (see "Bernanke is Underwriting the Wealthy" and "Bernanke is Underwriting the Wealthy: Part 2") must find other ways to prosper.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.