The Fed Is Not On Drugs, But Almost Everybody Else Is

by: Vahan Janjigian, CFA

Three weeks ago, the Dow Jones Industrial Average broke above 15,400 and many investors had 16,000 in their sights. The S&P 500 almost hit 1,670 with investors hoping to see 1,700 very soon. Then Ben Bernanke opened his mouth and everyone ran for the exists. Yet there was nothing that Bernanke said that we did not already know. He merely stated the obvious.

Unless you believe in fairy tales, you must have known that the Fed would eventually tighten. Before it could tighten, it would have to end quantitative easing (QE). And before it could end QE, it would have to taper. So what Bernanke said should not have caught anyone by surprise, yet investors reacted to his comments by selling everything. They sold bonds. They sold stocks. They even sold gold. So far this month, the yield on the 10-year Treasury note is up 36 basis points, the Dow is down 2.1%, the S&P is down 2.3%, and gold is down 8.7%.

Many investors are now focused more on what interest rates are doing than on what stock prices are doing. The yield on the closely-watched 10-year Treasury has climbed to 2.52%. I know this is a huge move from the 1.66% level it was at on May 1, but from the way some people are reacting, you would think the world is coming to an end. It's hard to believe they can get so excited about a yield this low. To put things in perspective, the 10-year Treasury was yielding close to 15% in 1982. Somehow, we survived.

Clearly, QE must end before we can get back to normal. Having the Fed purchase $85 billion worth of debt securities every month is not normal. Having a zero percent fed funds rate is not normal. Having a stock market that rallies every month for seven months in a row is not normal. Extremely low levels of volatility are not normal either. Ever since the financial crisis, the government has tried to eliminate risk from the markets. That is not normal. Investing is a risky activity and not everybody can make money all of the time. Until we allow people to lose money again, we will not be anywhere near normal.

There are those who have argued that the huge rally in stocks over the past several years was fully justified. They point to earnings growth, reasonable p/e multiples, and a strengthening economy. I don't buy this argument. On the contrary, I am convinced that the rally in stocks was largely of the Fed's making. I think the extent of this week's sell-off in reaction to Bernanke's comments makes that abundantly clear.

This does not necessarily mean, however, that the sell-off will continue. After all, the Fed is not yet ending QE. In fact, the Fed is not even close to ending QE. At the very most, the Fed might begin to taper QE later this year. But if things don't go according to plan, the Fed might actually take QE up a notch.

Perhaps we would all be better off if the Fed did not try to be so transparent. In the old days, few investors paid much attention to the Fed's actions. The Fed did not hold press conferences and the media did not scrutinize FOMC press releases or question Fed officials at length about monetary policy. However, these days, investors worldwide drop what they are doing at exactly 2 pm EST on every "Fed Day" to find out how the Fed's latest decision might impact their portfolios.

Given the recent gyrations in the markets, I decided to take a longer-term view. Unfortunately, I came up with four items that I think can threaten the long-term viability of the U.S. economy. Sorry to end this on a sour note:

Disparity in Wealth and Income. We've often heard that the rich are getting richer and the poor are getting poorer. The first part is true; the second part is not. While the poor are not getting poorer, they certainly are not getting richer either. Neither is the middle class. Even the merely wealthy are falling behind the very rich. While I oppose efforts to redress this problem by raising taxes on the rich, I do worry that the rising gaps in wealth and income could cause social unrest and severe economic disruptions. If we really want a healthy and vibrant economy, we have to figure out a way to make sure everyone is able to climb up the economic ladder.

Education. The U.S. is famous for its outstanding colleges and universities. U.S. colleges regularly dominate the global listings of best universities. Unfortunately, our secondary schools do not fare as well. Public school systems in many parts of the country are failing to provide the basic skills students need to succeed in life, let alone in college. In some cases, it even seems that the schools' primary mission is to provide a secure source of employment for teachers and administrators rather than an outstanding education for students. Perhaps this explains why U.S. universities have so many foreign-born and educated students, especially in graduate programs in the sciences, maths, and engineering.

Drug Dependence and Addiction. Apparently, physicians spend an inordinate amount of time writing prescriptions. A recent study from the Mayo Clinic concluded that about 70 percent of Americans are on at least one prescription medication. Approximately 13 percent rely on opioids to relieve pain and 13% are on antidepressants. Other than making an obvious case for buying pharmaceutical stocks, it isn't clear why such a large number of people require so many drugs. I'm beginning to wonder why the remaining 30% of Americans are not being medicated at all. Perhaps they haven't paid a visit to a doctor recently. Illegal drug use is also rampant. The owner of a foundry in middle America told me a few years ago that he wanted to hire more workers, but was having trouble finding people who could pass the drug test. I simply don't see how the employment situation can improve and the economy can thrive when so many working age adults are so drug dependent. In part, this may also explain why so many businesses are determined to automate. Robots don't get hangovers and they don't require rehab.

Debt. The financial crisis has prompted corporations and individuals to clean up their balance sheets. Unfortunately, the same cannot be said for the federal and local governments. If you include unfunded liabilities, such as social security, medicare, and pension funds, the national debt burden is astronomical and beyond the understanding of most reasonable people. Our collective debts are so large and growing so rapidly, that it is impossible to dig ourselves out of this hole without a complete change in attitude about entitlements and the role of government. That is not something I see happening anytime soon.