Stocks And The Fed: Less Would Be More

by: Eric Parnell, CFA

"Shut up shuttin' up!"

-Yosemite Sam

The Fed just can't seem to help itself. For a committee that was once legendary for its opaqueness and discretion, it seems that nary a day goes by anymore without someone from the Federal Reserve pontificating their views du jour about what might or might not be the next move on the monetary policy front. Despite what are likely the best of intentions with this steadily streaming communications strategy, the Fed would be best to step away and make themselves far more scarce at this point, as their daily words and seemingly never ending policy actions are undermining the normal functions of our free market system.

The past week provided just the latest example of the profound impact of the Fed on financial markets. On Monday morning, investors arose to a barrage of negative economic data. Pending new home sales disappointed, with a decline versus an anticipated rise, while reports on business activity from both the Chicago and Dallas Fed fell short of expectations. And these were just the latest in a wave of recent economic readings suggesting that recent signs of a fledgling economic recovery are on the fade. These latest developments on Monday should have induced the stock market to at minimum take pause if not decline for the day. Particularly following what has been a virtually uninterrupted +11% gain on the S&P 500 (SPY), year to date. Instead, the stock market jumped another +1.4% higher on Monday. Why? The Federal Reserve, of course.

Click to enlarge:

On Monday it was the Chairman himself that uplifted the markets at the NABE Economic Policy Conference. During his morning speech, he reminded the markets about the Fed's willingness to provide continued monetary accommodation, which many investors read as hints that another round of monetary stimulus would soon be on its way. Never mind that such conclusions were diametrically opposed to the read on the Fed announcement following its meeting on March 13, when many investors were dismayed by no hints of further quantitative easing were included in the statement. And these are just two of many recent examples of the market disregarding economic data and instead hanging on nearly every single word from every Fed representative on an almost daily basis.

This continuously overhanging influence by the Fed raises some important points.

First, it is unhealthy for a free market capitalist system to largely ignore the fundamental economic information and instead focus on what the latest policy insinuations from the Fed might be. At some point, markets will move to reflect the underlying realities of the economy. The further stock prices are induced to move from their normal equilibrium prices in the meantime, the more painful the eventual adjustment will be. These, of course, are the forces that create unsustainable bubbles.

Also, it cannot be in the Fed's best interest to have its public speeches and anticipated policy actions so meaningfully distort how the stock market might otherwise trade on any given day. This essentially transforms the role of the Fed from a distant overseer of market activity to that of a centrally involved force in driving the day-to-day movements of the market. And associated volatility is amplified when the sentiments coming from the Fed become capricious. The consequences of this influence is that it not only disrupts the normal price discovery mechanism, but it also threatens to leave a potentially gaping void in the markets once the Fed either wishes or needs to vacate this role.

In addition, the Fed's focus on the stock market seems to be leaning toward obsessive at this point. Markets must have the ability to go down as well up over short-term periods of time. Otherwise, markets are not functioning properly. And the Fed would be well served to allow markets to enter into periods of short-term correction and resist the urge to parade out a committee member with comforting words to try and influence markets every time it is down a handful of points over a few days.

Unfortunately, the Fed has created an environment where investors are hooked on policy stimulus and every word of policy makers like a drug. Addiction is never a good thing, particularly when the time comes for the detoxification process.

I am personally perplexed by the continued preoccupation, bordering upon fetish, that Wall Street exhibits regarding the potential for further monetary accommodation-the so-called QE3, or third round of quantitative easing.

-Dallas Fed President Richard Fisher, March 5, 2012

Trillions of dollars are lying fallow, not being employed in the real economy. Yet financial market operators keep looking and hoping for more. Why? I think it may be because they have become hooked on the monetary morphine we provided when we performed massive reconstructive surgery, rescuing the economy from the Financial Panic of 2008-09, and then kept the medication in the financial bloodstream to ensure recovery.

-Dallas Fed President Richard Fisher, March 5, 2012

His words, not mine. But I agree completely with Mr. Fisher on all of his points from early March. And it raises some critical questions as we continue to work our way out of the crisis that began several years ago.

If monetary stimulus has not succeeded in propelling the economy into a sustainable growth trajectory by now, and trillions of dollars already in the system remain unemployed, why exactly does it make sense to apply additional stimulus going forward? The idea of pushing stock prices higher in order to create a wealth effect that will boost the economy is simply not working in a sustainable way. And the idea that a rising stock market will somehow inspire confidence in the economic outlook is misguided. Instead, it is creating even more distrust, as most investors observe that the steadily rising stock market does not at all reflect the economic realities that they are living every day. Such investor suspicion is clearly evidenced by the steady stream of outflows by retail investors from the stock market that has remained ongoing for a few years now.

Click to enlarge:

Also, stock prices are not the only thing rising as a result of Fed stimulus. Oil and gasoline prices are also rising, and at a rate that is greater than stock prices. With this in mind, and given the fact that only 54% of the American public is invested in the stock market according to a Gallup poll that was taken just before the latest market shock in August 2011, does it really make sense to continue trying to stimulate the economy by boosting the fortunes of 54% of American stock investors at the expense of the near 100% of Americans that have to either fill their cars up with gasoline and heat their homes with oil every day? A policy is in place that effectively taxes everyone in this country to help support only 54% of the population with a wealth boost that largely is not being spent and evaporates the moment policy support is removed. Does this truly make sense in trying to achieve sustained economic growth? It has not worked to this point, and it is unlikely that it will have any better luck in the future. Particularly if consumers are forced to pay increasingly higher prices for oil and gasoline.

Perhaps it is time for the Fed to consider a fresh approach. At this stage, it is time for the Fed to stand back from its QEs and Operation Twists. The actions taken in the early days of the financial crisis to rescue the financial system were warranted, and I applaud them for their work, including the implementation of QE1. But we are now over three years on from the crisis. And at some point the market system is going to have to stand on its own before the economy can truly return to normal. The longer the Fed remains insistent on engaging in so much conversation and so much action, the more distorted markets will become and the more painful the ultimate detoxification process will eventually be. Moreover, the risk is rising that they may ultimately drive the economy to a considerably worse outcome that starts with "s" and ends with "tagflation" (I will be expanding on this topic in a separate article in the coming week). The sooner the Fed steps away and allows financial markets to operate on their own, the better.

In the meantime, I am neither a member of the FOMC nor do I have any say whatsoever in the monetary policy actions of the Federal Reserve. As a result, my priority remains to position for opportunities that present themselves in the Fed-influenced market environment. Leading among these is an allocation to stocks, particularly given the high priority the Fed places on the asset class. The focus remains on the more defensive companies that are better equipped to hold up during any correction phases and have trailed the broader market on a relative basis during the recent rally year-to-date. Representative names include McDonald's (MCD), HJ Heinz (HNZ), General Mills (GIS) and Tootsie Roll (TR).

Click to enlarge:

Given that stocks stood alone in posting strong gains in the first quarter, the best opportunities now reside in other asset classes that did not fully participate in the advance, if at all. This includes categories that should directly benefit from further monetary stimulus. These include Gold (GLD) and Silver (SLV) as well as High Yield Bonds (HYG) and U.S. Treasury Inflation Protected Securities (TIP). And if the realities of an economic deceleration finally begin to set in on the market, more defensive categories should benefit, including Agency MBS (MBB), Municipal Bonds (MUB) and Build America Bonds (BAB). And Long-Term U.S. Treasuries (TLT) remain an attractive hedge against a declining stock market.

At some point the Fed will finally step away with a little less conversation and a little less action. Until then, it is important to stand ready for the daily unpredictable swings that can accompany the words from a Fed policy maker on any given day.

Disclosure: I am long BAB, GIS, GLD, HNZ, HYG, MBB, MCD, MUB, SLV, TIP, TLT, TR.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.