Our 'Dumb and Dumber' Economic Policy

by: Geoff Abbott

We've seen this movie before. Yesterday's sharp sell-off notwithstanding, stocks have been steadily rising. Investors are ebullient. Their appetites for risk are insatiable. Corporations are reporting record profits. Analyst estimates point skyward. All is right in the world.

Commodity prices are rising too. Our omniscient Federal Reserve assures us that the price increases are the result of legitimate supply-demand imbalances. We are told that the Fed's money-printing has caused neither the buoyant prices nor the resulting havoc wrought on American wallets. Prices will come down. The economy will grow. Again, all is right in the world.

So what is this movie and when have we seen it? The movie is Dumb and Dumber, and though it was released in 1994, the movie is pretty useful in helping us contextualize how misguided and destructive our fiscal and monetary policies have been in the past few years. The last time we saw pervasive investor bullishness coupled with absurdly loose monetary policy and a reassuring Fed was in late 2007. Stocks were hitting all-time highs and commodities were marching onward and upward, even as the cracks in the housing market were starting to become gaping fissures.

I often say to my friends and colleagues that we must laugh at the world's depressing news because it beats the hell out of crying. To that end, let me expand on the Dumb and Dumber analogy. I'll briefly summarize the plot for those who haven't seen the movie or who need to have their minds refreshed. Harry Dunne (Jeff Daniels) and Lloyd Christmas (Jim Carrey) come into possession of a briefcase containing a million dollars of cash. This money belongs to mobsters, but Harry and Lloyd spend the movie trying to return it to the woman they believe to be the rightful owner.

Early on in the movie, the mobsters decapitate a small canary belonging to Harry and Lloyd's blind neighbor. Harry and Lloyd simply tape the bird's head back on and return it to its owner. This is where Harry and Lloyd prove themselves Bernanke/Obama/Bush's equals. Rather than spending the time to find a real solution to the problem at hand, they tape the bird's head back on.

When the economy plummeted in 2008, Lloyd Christmas, er, Ben Bernanke did everything he could to tape the head back on the American economy. He joined forces with Paulson, Bush, and the feckless US Congress to devise short-term "solutions" to a long-term problem. Our leaders devised a brilliant solution: Solve a debt crisis with more debt and reflate bursting asset bubbles caused by liquidity with more liquidity. They eschewed long-term prudence for short-term expediency. President Obama has proven himself no more willing or able to generate real solutions. In many ways, he has been more clueless than his remarkably clueless predecessor.

(Note: I acknowledge the flaw in my analogy; it would be more fitting if Lloyd Christmas had had a printing press rather than the comparatively paltry sum of one million dollars.)

Now, three years after we "did the right thing for the country," our economy is slowing once more. After TARP, TALF, the auto bailouts, a huge stimulus package, and two rounds of money-printing, growth looks anemic and is getting more so. Meteoric rises in financial markets have them priced for many more large declines like yesterday's. Bernanke and Obama are similarly positioned to Lloyd and Harry at the end of their movie -- they've spent a tremendous amount of someone else's money, issued IOUs for it, and they've acquired lots of new bells and whistles along the way.

However, Bernanke and Obama's endeavors have left us no better off than we were when they started down the path of more debt and liquidity. And, like our heroes at the end of the movie, they're out of ammo and out of time. The US government no longer has the financial flexibility, and the Fed doesn't have the credibility, to fight the flames of economic weakness.

Now for the important stuff: What are the investment implications of this failed policy? Don't take anything I've written here as a prediction of imminent doom. That's not what it is. However, it's important to take stock of all the risks we face in the context of today's high risk asset prices.

Stocks are priced for perfection, and investors have been mostly euphoric about equities for the past year. The wide and growing disconnect between stock prices and economic reality should make us defensive. I'm not predicting lower stock prices, but every investor should be aware that stocks are highly likely to go much, much lower over the next 12-18 months. Investor enthusiasm and economic weakness do not produce bull markets.

Despite my pessimism, our fund isn't aggressively short. We must all remain prepared of the possibilities of QE 3, 4, and 5. Sure, QE 1 and 2 didn't boost the economy in any sustainable way. But central bankers' remarkable ability to be wrong is eclipsed only by their even greater capacity to ignore their own mistakes. Those who do not understand history are doomed to repeat it, and those who deliberately ignore it are likely to become chairman of the Fed.

Investors should own the few high-quality cheap stocks that are available now. Take a look at Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), and Walmart (NYSE:WMT). They should short the absurdly-priced stocks of companies with questionable business models. Salesforce.com (NYSE:CRM), OpenTable (NASDAQ:OPEN), and Rackspace (NYSE:RAX) are good places to start. The way forward is uncertain, but we can best prepare ourselves for what lies ahead by placing prudent, two-sided bets.

Disclosure: I am long AAPL, MSFT, WMT.

Additional disclosure: I am short CRM, OPEN.