"Investors like things that appear certain. My view is that everything is uncertain, you're just trading one type of uncertainty for another." -- Seth Klarman
In a CNBC editorial titled "Don't blame China for the market sell-off", published Wednesday, January 6th, 2016, Richard Fisher, the former President of the Federal Reserve Bank of Dallas, gave rare insight into the Federal Reserve's view on the wealth effect.
With an eloquence and transparency that is rare in the modern world of central banking, where investors often feel like participants at a magic show, Mr. Fisher outlined the rationale behind the Fed holding interest rates at zero. The following are two direct quotes from Mr. Fisher, copied and pasted from the published article:
I spent 10 years (through last March) as a participant in the deliberations of the Federal Open Market Committee, setting monetary policy for the U.S. The purpose of zero interest rates engineered by the FOMC, together with the massive asset purchases of Treasury's and agency securities known as quantitative easing was to create a wealth effect for the real economy by jump-starting the bond and equity markets.
Clearly, the reaction of the bond and equity markets was important to create a wealth effect. Fisher continued:
The impact we had expected for the economy and for the markets was achieved. By February of 2009, the Fed had purchased over $1 trillion in securities. With interest rates throughout the yield curve moving in the direction of eventually resting at the lowest levels in 239 years of history, the stock market reacted: It bottomed in the first week of March of 2009 and then rose dramatically through 2014. The addition of a third round of QE, which had the Fed buying $85 billion per month of securities to ultimately expand its balance sheet to over $4.5 trillion, juiced the markets.
Given the green light by the traffic cops of the financial markets in 2009, speculators leveraged up, and the so called wealth effect was put into high gear. Confidence was restored, at least temporarily, and maybe not for the reasons attributed by Fisher, but in any case the infallible belief in the Fed's restorative powers, was emboldened.
Those with the first access to subsidized, cheap money, benefited the most, and the widening of the wealth gap between the "haves" and "have not's," further inflamed a societal wound that is being expressed in the current state of presidential politics.
Along the way, to the Fed's envisioned economic paradise, where the wealth effect benefited all, side effects occurred. Too big to fail banks got bigger, stocks with any resemblance of growth were bid up beyond reason, and low interest rates encouraged zombie companies to stay in business, while all but forcing healthy companies to issue and layer on debt.
The drug is wearing off, and investors are realizing that perhaps the Fed is not the answer. The resulting investment environment, which has been distorted by the largest quasi-government intervention in history, is akin to the aftermath of a warzone, with historically cheap stocks standing side by side with historically expensive equities. For an opportunistic investor, it is a dream environment, yet the remaining risks are significant. The following is an overview from my perspective.
Global stock markets and bond markets are starting to reject the constant central bank intervention, seeking their fair values despite all efforts to discourage capitalistic behavior.
Bonds Have Outperformed Stocks
Despite the vigorous rally in the S&P 500 Index over the past week, as measured by the SPDR S&P 500 Index ETF (NYSEARCA:SPY), bonds, as measured by the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) have resumed their performance leadership over stocks.
Building on this point, the S&P 500 Index has been one of the leading performers on a global basis, with SPY strongly outperforming the iShares MSCI Germany ETF (NYSEARCA:EWG), the iShares MSCI Japan ETF (NYSEARCA:EWJ), and the iShares MSCI All Country World Index ACWI ETF (NASDAQ:ACWI), as illustrated in the chart below.
When looking at the above chart, it should be clear that the wealth effect has largely been a mirage, a simple magician's trick that is being rapidly discovered by financial market participants.
Growth Stocks Have Outperformed Value Stocks
With good intentions, the Federal Reserve, to paraphrase Mr. Fisher's quoted words in the opening paragraph of this article, encouraged speculation. In a world that was deflating from prior excesses, the "hot money" looked for growth opportunities, and growth has outperformed value for the trailing one, three, and five-year time frames.
The performance gap of 13%, opened up early in 2015, as large capitalization growth stocks like Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Alphabet (NASDAQ:GOOGL), (NASDAQ:GOOG), Verizon (NYSE:VZ), Coca-Cola (NYSE:KO), Walt Disney (NYSE:DIS), and Home Depot (NYSE:HD) received the lion's share of capital inflows from both individual and institutional investors. While the rest of the markets, led by transportation and small-cap stocks sold-off, foreshadowing the loss of confidence in August of 2015, the shareholders of the largest stocks marched forward, with nary a worry in the world.
The holdings of the IWF are shown below. Notice the weightings of the individual companies in the IWF, with the top-ten holdings representing roughly 24% of the IWF.
It is interesting that Apple continues to represent nearly 6% of the IWF, while the two shares classes of Alphabet account for a substantially smaller weighting, even though Alphabet, briefly, surpassed Apple for the title of the world's largest company. Since that highly publicized moment, Apple has regained that crown.
Overall, the performance of the IWF is heavily dependent upon Apple's shares, and information technology in general, as they dominate the holdings of the IWF. Reflective of a growth fund, its portfolio characteristics are not cheap.
For comparison, let's examine the holdings and portfolio characteristic of the IWD, which are shown below. The top ten companies include Exxon Mobil (NYSE:XOM), General Electric (NYSE:GE), Johnson & Johnson, (NYSE:JNJ), Berkshire Hathaway (BRKB), Wells Fargo (NYSE:WFC), Procter & Gamble (NYSE:PG), JPMorgan Chase (NYSE:JPM), AT&T Corp (NYSE:T), Microsoft , and Pfizer (NYSE:PFE).
The top-ten holdings of the IWD compromise roughly 25% of its weighting, and these companies are more diversified than their top-ten IWF counterparts. As group, they are cheaper, have higher yields, and lower volatility.
To close, large-cap value stocks appear to be more fairly valued than their large-cap growth peers. Apple supporters can make the case that AAPL shares should be a value stock, similar to the dually held Microsoft, and I believe there is a good case for that position.
Momentum Growth Stocks Have More Room to Fall
Even though the average stock has declined more than 25% over the past year, U.S. small-cap stocks are in a bear market, and leading transportation stocks have led to the downside, and are firmly entrenched in their own bear market, there has been a strong cohort of voices in the financial media saying that investors should buy the dip, as this is another August sell-off, and the markets could make new highs.
While this is possible, and I continue to study these views to formulate probabilities, I believe that the broader market indices in the United States have further room to fall. In a potential reverse image of the move higher over the course of 2011-15, I believe the prior leading stocks, which include both the largest market capitalization stocks and momentum favorites, could now front-run the remaining decline.
While all of these stocks have moved sharply lower over the past two months, each company's stock still sports substantial gains over the trailing five years, far outpacing the returns of the SPY. Thus, in a risk-off environment, these shares remain vulnerable, in my opinion.
Perhaps the best risk/reward shorting opportunity, in my opinion, is in shares of Facebook.
Unquestionably, Facebook dominates its markets, as the following graph, pulled from an excellent overview of social media, shows.
The fact that Facebook has precious few new markets to dominate, is in a notoriously competitive technological field, and is already universally loved by institutional and retail investors, means that the company could simply be over-owned and overvalued. Thus, for a portfolio hedge, I recommend shorting Facebook. Alternatively, an under-owned, potentially undervalued stock, like Twitter (NYSE:TWTR), presents a long opportunity.
Out-Of-Favor Stocks Attract Interest
While central bank's low interest rate policies encouraged financial market speculation, they inhibited the cleansing process of capitalism, and they re-directed capital flows away from emerging markets into United States.
This backdrop of low interest rates and low economic growth, which may not be mutually exclusive, has decimated emerging markets. As emerging markets, the last remaining viable true growth alternative faltered, commodity demand slowed from the prior breakneck pace.
This crushed both emerging market stocks and commodity stocks. In fact, it created the perfect storm for United States domiciled commodity producers, as lackluster commodity demand combined with a stronger dollar, were simply too much to overcome.
As the financial markets have come to the realization that the U.S. is not decoupling from the rest of the world, the prospects for future rate hikes have markedly diminished over the past two months, to the point that no additional rate hikes are expected from the Fed in 2016.
Not surprisingly, this has weakened the dollar, and put a bid under commodity stocks. Value investors like Warren Buffett, with his purchase of Kinder Morgan (NYSE:KMI), have been busy picking up shares, and out-of-favor stocks like Freeport-McMoRan (NYSE:FCX), and U.S. Steel (NYSE:X) have started to rally after being in their own bear markets ever since 2011.
The price gains in this burgeoning rally might seem like the stocks have come too far, too fast, but when looking back at the performance of these shares over the past five years, it should become evident that there are large potential gains if, we have indeed, reached an inflection point. Thus, opportunistic investors should be examining these companies for opportunities.
Building on the list of potential opportunities, emerging market shares remain cheap, and this is perhaps best exemplified by the performance of the iShares China Large-Cap ETF (NYSEARCA:FXI) versus the SPY over the past five-years.
Which market would a value investor buy today?
Conclusion - Central Banks Have Created Chaos
Stocks prices, interest rates, and commodity prices remain distorted, primarily due to the influence of activist central banks. Over the long-run, market interventions, spurred on by even the best of intentions, historically do not work.
Ironically, the Federal Reserve has tried to create an inflationary environment, but the world has been mired in a dis-inflationary bust, where capital flows have been recycled back to the United States. This is priced into the investment markets, with global sovereign bond yields approaching all-time lows.
In an environment where everyone is worried about deflation, and this has been priced in, perhaps it is time to reallocate and overweight inflationary assets, like emerging markets and commodity stocks. If you are not that adventurous, consider raising cash on market rallies, overweighting value over growth, and looking for out-of-favor investments to compliment your portfolio. From my perspective, it is time to make lemonade out of lemons. It is time to be a contrarian. For more information, please follow this link.
Disclaimer: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
Disclosure: I am/we are long FCX, KMI, TWTR, X, AND SHORT AMZN AND SPY.
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.
Additional disclosure: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.