A Tale Of 2 Federal Reserve Chairs

| About: SPDR Dow (DIA)

Summary

Federal Reserve policy is the overall driving force behind current market mechanics.

Janet Yellen's predicament today is compared to Paul Volcker's predicament in the 1980's.

Comparisons drawn to today's market.

I think I'm having déjà vu.

On June 7th, the Dow (NYSEARCA:DIA) once again broke 18,000. Headlines were bullish on all the big financial aggregators - this is the time we're going to break the ceiling and reach new highs. Since then, the Dow has closed negative 6 times and now sits at 17,675.16. Another rally has failed.

Since reaching an all-time high of 18,351.36 intraday on Tuesday, May 19, 2015, the Dow has broken through the psychologically-important 18,000 ceiling 5 other times before retreating back into the 17,000's:

Date Intra-day High
6/10/2015 18,045.14
6/18/2015 18,174.73
7/14/2015 18,072.82
4/18/2016 18,009.53
4/26/2016 18,043.77

The 1-Year chart of the Dow and S&P 500 (NYSEARCA:SPY) look like seesaws with a clearly-defined top.

In order to understand the market, we must first acknowledge that there is, of course, no "ceiling" to the stock market. This pattern is behavioral - the 18,000 Dow/2,100 S&P 500 points of resistance are artificial constructs inside the minds of investors. Since the stock market is nothing more than a glorified auction house, what we are seeing is a pattern of investors timidly bidding historically overvalued stocks up, growing more confident as momentum builds, but then when the artificial ceiling is reached, they look for negative headwinds, panic, capitulate and the process starts all over again.

For my thesis to be correct, there has to be something influencing that behavior. I believe that the Federal Reserve is the influence, and is the driving force behind the seesaw that is the US stock market.

Janet Yellen's Disturbing Lack Of Vision

The power of the Federal Reserve has grown to enormous proportions. So vast is their reach that investors seem more concerned with analyzing the words coming out of Janet Yellen's mouth than they are with the actual fundamental health of the US economy. Rather than applying good old fashioned valuation metrics to equities to gauge market health, investors seem more concerned about what the Fed will or will not do to influence the market.

As a result, Janet Yellen just may be the most powerful person on Earth - no one's voice affects the worldwide economy more than hers. A wise man once said, "With great power comes great responsibility," and with Yellen's tremendous power comes a tremendous responsibility to the citizens of the United States of America and the rest of the world. Uncertainty is the market's worst nightmare, so Yellen as I see it has a fundamental responsibility to all of humanity to outline clearly-defined policies for tackling the economic challenges we currently face while having a very long-term approach. Yellen should be managing the markets like a smart, responsible young person should be managing their retirement portfolio - create a clearly defined plan now regardless of how difficult it may seem in the present because a clear plan will pay off huge down the road. No matter how tough sticking to your plan seem now, trust me, it'll be way easier NOW than waiting until it's too late and trying to play catch-up in the 11th hour.

Instead, Yellen has done the exact opposite. She has been dangling interest rate hikes over the market for a year now, never outlining a defined plan of exactly when rates will be hiked and exactly how much. As a result, we are seeing a seesaw effect in the market as every single jobs report is released and investors try and speculate what she'll do based on the report.

Mere weeks ago, the market was betting increasingly that Yellen would raise interest rates in June. Last week's meeting took that scenario off the table. Instead, Yellen left us with a statement that a rate hike is "not impossible by July."

That type of statement is precisely why, in my opinion, that Janet Yellen is an absolute failure as chair of the Federal Reserve.

Excuse me, but exactly what kind of statement is, "It's not impossible by July"? I can already see the future: We will wait until the next jobs report is released, the market will react based on the jobs report, speculate whether or not interest rates will go up, down or hold at the July meeting, and then the market will again react to Yellen's statement. The end result is we will have another volatile month on our hands as speculators panic in both directions as they try and make sense out of uncertainty.

The US economy cannot be managed month-to-month with lukewarm policy wavering every time 'Monthly Report X' and 'Weekly Report Y' comes out. That is not how you make smart decisions as a manager. A smart manager makes decisions based on a long horizon. A smart manager has a vision of how they want their world to be a decade out or more, reverse-engineers a way to get there, then systematically executes the plan step-by-step, sticking to the plan and never wavering in attaining their goal. Instead, we have developed a culture of meekness where no one is willing to make the tough decisions today because they don't want to be blamed for any short-term pain tomorrow that may result.

Paul A. Volcker - The Anti-Yellen

Last week, Seeking Alpha contributor Eric Parnell wrote an article summarizing his feelings on the market's long-term outlook under the current weak leadership who are more concerned with winning battles than winning wars, as he put it. The article turned into a bit of a history lesson. Parnell briefly brought us back into the 1980's when Fed Chair Paul Volcker ran things. I was born in 1986, so my memories of this time are non-existent. I am, however, a student of history, and let's just say they don't make 'em like Volcker anymore. He was a man, which is a tough thing to find in today's America. Contrary to what my generation of Millennials may think, there is more to being a man than growing a beard.

The 1970's was a miserable financial time in America. The stock market had lost 40% of its value, gasoline prices were at historical highs was rationed nationwide, we had lost the Vietnam war and disco music proliferated the airwaves. But as bad as all those things were, the most dangerous threat facing the United States of America was inflation.

Inflation began spiking after in 1965. Throughout the 1970's, inflation raged at out of control at rates, eclipsing 13% near the end of the decade. It was a storm of epic proportions - horrific stock market performance and sky high energy prices were being tag-teamed with enormous price increases to the already broke American consumer. Imagine a world where you were purchasing items today simply out of fear that they'd be significantly more expensive tomorrow - that is a reality many of us have never experienced. People were buying homes out of fear the prices would skyrocket. The devastating implications of that behavior cannot be overstated.

When Paul A. Volcker became chairman of the Board of Governors of the Federal Reserve on August 6, 1979, he had quite the mess in front of him. Did Volcker react by pussyfooting around, babying the markets with uncertain policy to avoid being blamed for any misstep? Absolutely not. Volcker reacted with a cast iron grip and strangled the dear life out of inflation by cutting off the money supply and jacking interest rates through the roof.

As a result, the stock market plunged.

Volcker responded to the market plunge by doing something unique: he stuck to his guns and held interest rates high for years. He held them near all-time highs until nearly 1983, where rates began to relax to more historically "normal" rates until his tenure ended in August 1987.

Something amazing happened during this policy experiment. The market skyrocketed to heights never before seen at an astounding rate of speed.

Now, let's not be foolish and think this is all Volcker's doing. The 1980's were a tremendous time for America - the Reagan years were quite good, and a little thing called "the computer" was starting to find its roots. America was just getting warmed up for the technology explosion. What was amazing during this market explosion, however, was inflation.

Despite a skyrocketing stock market and rapidly falling interest rates, inflation fell rapidly as well. America was wealthier than ever, and prices were stable. This was a great time for the explosion of wealth in this country. But how can this be? What made such a wonderful confluence of events possible? In 2015, NPR correspondent David Kestenbaum crafted a piece titled, "How Former Fed Chairman Paul Volcker Tamed Inflation - Maybe For Good," where he came up with a great theory on why this is the case. The main culprit: human psychology.

People buying houses because they think they will go up in price - that is not good. Volcker believed he had the key to stopping inflation. The Fed's job was to control how much money was in the economy. And Volcker thought it had simply printed too much. So shortly after he took office, he made a big announcement. The Fed was going to tightly restrict the amount of money in the economy. The result - not what he had hoped. The thing he was trying to fix, inflation, got worse. It went from 12 percent up to 14 percent...

...In the textbooks, once you stop printing so much money inflation should go away. But it was taking a long time. One reason it was taking so long - people did not believe inflation would go down. Part of the problem was in our heads. If people believe there's going to be inflation, then they go to their bosses and they say, you got to give me a raise to keep up with inflation. Employers say, OK, and to pay for those higher wages they raise prices for whatever they sell. There you go - inflation. It's a self-fulfilling prophecy. Volcker stuck to his guns, limited the amount of money in the economy. And by the end of 1981, inflation finally began to drop - 9 percent, then 6 percent, 4 percent.

That was the reason why Volcker's method worked - he kept his foot on the gas, strangling the money supply until people got it branded in the back of their skulls that this is the "new normal." And once people adopted a "new normal" in their minds, prices began to regulate. It takes a long time for human beings to develop new habits and break old habits, and it took years of strangulation for us to do so.

But through it all, Volcker never doubted himself, right? Wrong. From the same article, past audio of Volcker emerges of when asked if he ever doubted himself.

I never had a doubt in my life (laughter). Of course - of course - of course you worry.

When asked about if he had any regrets, Volcker had this to say.

Regrets about what? I got regrets every day I'm sitting here. I don't have any regret that we carried out a fight on inflation.

Key Takeaways

One can draw many parallels to Volcker's conundrum and the current conundrum facing the market.

  1. Volcker was ultimately successful because he devised a concrete plan and executed it mercilessly for years. Yellen, on the other hand, refuses to devise any concrete plan and is content with keeping the markets guessing.
  2. Volcker was able to beat inflation by psychologically transforming the masses. The masses believed that inflation was the "new norm," and as long as the people reacted to that idea, the idea would become reality and propagate throughout the markets. Volcker crushed that notion by making it prohibitively expensive to borrow money. Tightening the money supply to such a degree forced people to adopt a new reality - a reality where inflation was no longer a threat.

    Right now, Yellen's uncertainty and weakness has people without a vision of Future America. Will she raise interest rates in July? Will she cut them? Will rates go negative like in some parts of the world? Nobody knows. Yellen has forced a type of ADHD onto the market - investors cannot focus on the future because they have no idea what kind of future to plan on. Yellen is promoting a culture of mayhem.

  3. Volcker was willing to make the tough decisions and take responsibility for the consequences - and boy, was he demonized in the beginning when his rate hikes tanked the market. So maligned was he initially that homebuilders mailed pieces of wooden two-by-fours to the Fed out of anger for the plunging demand for new homes. But in the end, he was vindicated and we are a stronger nation today because of it. If Yellen continues to take the coward's path and refuses to devise a concrete plan for fear of being held responsible for any short-term pain, we will continue to see this seesaw of uncertainty in the market.

I believe the market is trading within this range because, psychologically, that's where investors are used to trading. Every time the Dow falls around 17,000, investors feel it's too low and bid it up. Every time the Dow touches 18,000, investors feel it's too high and panic. It's a real-life psychology lesson in human behavior. But the market can only remain range-bound for so long. Eventually, it needs to break out - either up or down.

Given the fundamentals - quarter after quarter of shrinking profits, expanding price multiples, ballooning debt from years and years of ZIRP-encouraged buybacks at high multiples, low commodities prices still hurting the energy sector - I believe when the camel's back does break, we are likely to break to the bottom. The uncertainty that Yellen is forcing upon the markets may actually be prolonging the plunge as investors continue chasing their tails instead of examining the hard data, but the longer the eventual fall is postponed, the further the fall tends to be when it happens.

Disclosure: I am/we are long 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: All information found herein, including any ideas, opinions, views, predictions, commentaries, forecasts, suggestions or stock picks, expressed or implied, are for informational, entertainment or educational purposes only and should not be construed as personal investment advice. I am not a licensed investment adviser.

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