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The Fed's Misguided Search for Instant Gratification

Bernanke has admitted that QE2 is intended to prop up the equity markets, resulting in a "virtuous circle" of asset appreciation. This is frankly astounding to me, as it clearly is to many overseas finance ministers. When has the Fed EVER been successful in creating "virtuous" asset value expansion? Once they begin manipulating asset values, you can be certain a bubble will follow.

This is the same Fed that claims it is impossible to know when a bubble exists. Yet they are clearly trying to precipitate yet another one so soon after the spectacular implosion of their last creation, the real estate bubble. Dylan Grice, Soc Gen's uncommonly rational equity strategist and ardent believer in both value and psychology's influences on the market, summed it up well in his recent installment of "Popular Delusions":

Humans innovate. The economy grows ...  and all, until very recently, without QE! Maybe someone should tell our central bankers? I’'m not sure why, but they seem to think that the economy only grows because they stimulate it. Economy not growing fast enough? Stock prices not high enough? Consumers not confident enough? Households saving of all things? Why, it can only mean one thing – - we’re not stimulating hard enough!

Why is it that the central bankers who lecture the world on the efficiency of the market mechanism to set prices don'’t trust that same mechanism to efficiently set the economy'’s cost of capital?

Amen!! Bond bubble? Check! Commodity bubble? Looming! Equity bubble? Stay tuned!

The Fed has clearly annoyed the heck out of just about every other functioning economy in the world. The Media was full of quotes, Op-Eds and interviews clearly demonstrating that our overseas friends are none too amused by the Fed printing even more boatloads of money when it clearly isn't needed. If this was the right thing to do, I might not care too much what they think, but banks are flush with liquidity. Our economy is NOT liquidity constrained. But meanwhile the Fed decides to print more in an effort to manipulate the stock market upwards and make consumers feel better about themselves. Who cares if they start a trade war, as long as Mr. Market is happy IN THE NEAR TERM?

I can't see how this is any more than a short term binge that ends quickly and badly. John Hussman calculated that even if Mr. Market drove the economy (and not the other way around), history shows that a 10% market rally only "results" in incremental economic growth of less than one half of one percent over two years (and then followed, by the way, by a decline that wipes out this "benefit").

One of Buffett's mantras is that one should always stick to what they know, stay within their circle of competence. This is lost on Bernanke. In his Washington Post Op-Ed he states that the Fed is charged with promoting a "high rate of employment and low, stable inflation". So how does this include inflating asset prices and manipulating markets? Bernanke even says that the 2% inflation rate is "a bit below" the Fed's preferred rate. How does that justify even more "stimulus" in the face of already historically low interest rates and massive dollar debasement?

It's the unemployment rate silly! Clearly the Fed thinks that blowing dollar bills up Mr. Market's skirt will result in more jobs. As spurious as this logic is, the real problem is that the high employment rates of last decade were a mere illusion also created by the Fed. The jobs created by the real estate bubble - construction, finance, retail, real estate, etc etc, are not coming back any time soon - they never should have existed in the first place. The Fed's last experiment in market manipulation pulled back years and years of future job growth into a short boom period, only to have it spectacularly implode. Add to this the fact that our county is undergoing a permanent structural shift in economic activity. Most basic manufacturing jobs are not coming back - ever. So until we are able to shift to new industries, and create workers with new skills, no amount of funny money will bring back these jobs.

Even so, the Fed should sit back and let the economy work. It should keep its hands out of the markets. It has done more than enough.  Commodity inflation is as clear as the beard on Bernanke's face, even if "core" CPI numbers tell the Fed that inflation is a "bit low". If this real world commodity inflation gathers some steam, which seems likely as a consequence of QE2, I can't imagine how it has a positive effect on the economy.


Yet, against this lovely backdrop, Mr. Market is getting giddier by the day. Why? Because Ben told him to! After all, you can't fight the Fed. Until you can - its just hard to tell when that moment will arrive.

As a value investor, these are the times that try my soul. The bargains available only months ago are largely gone. Most stocks appear fairly to overvalued. My gut says we are WAY overdue for a serious correction. But there is a good chance the market will run through year end. I have some cash in my portfolios, and I have been trimming positions with high weights and/or high valuations. So my cash slowly grows. I am not a market timer, just a value guy, and my valuations are telling me this is what I should do now. I am not the kind to go completely to cash based on my gut or my models. I prefer to hold as long as possible and stay as fully invested as possible, but I won't commit cash to new investments if valuations are unappealing - even if Mr. Market looks to be setting himself up for a holiday binge.

Hey - if you or I were able to manipulate financial markets and print money, we'd wind up in jail.


Disclosure: No Positions