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Waiting For The Squirrel

Spring has finally begun to show itself here in Michigan. It has been a brutal winter.

Molly, our six-year-old, loveable mutt (of "Where's Molly" fame), loves the new freedom that warmer weather brings. She bounds from the door each chance she gets and instead of the quick return that the winter's cold elicited, she is gone for hours.

Where does she go? First there is a quick reconnaissance of the property, carefully sniffing every square inch it seems. Then, she's caught the scent. A flash of movement catches her eye. It's her arch nemesis-the squirrel.

If the squirrel happens to be on the ground, it quickly scampers up a tree. Once it reaches its perch, or if it is already high above Molly, it taunts her, chattering away at his foe.

Molly is undeterred by the squirrel's rant. She settles in on a rock below the tree … and waits. She is totally focused on that patch of sky that encompasses both branch and squirrel. An hour later, neither squirrel nor Molly has moved. Yet still she waits. Only when meal time comes does she abandon her self-appointed post. She never catches the squirrel.

For some investors, the financial markets provide the stage for a reenactment of this same script. They are always waiting for something. Is the bear market on the way? Has the bull market begun? Is the end at hand?

The problem with waiting without a plan is that it paralyzes the investor. As a result they suffer. Whether they miss an opportunity or suffer a costly defeat due to waiting, their delay can hurt performance.

Yet such delay is really a learned behavior. Investors have acted in the past and then been badly burned, as well.

Of course, this learning process easily falls into a cycle. You are burned by action, so you delay the next time. That turns out badly and the time after that you rush to commit. It's a very damaging cycle. It's one of the reasons why most individuals going it alone so often underperform, even when they are choosing good investments.

We believe the answer is to avoid this very human behavior by employing computer-driven strategies. These mechanical methodologies supply the discipline to simply follow a plan without the emotional involvement.

These systems, too, can be out of synch with markets, but it is not because of emotions or past failures. And regardless of the outcome of the last trade, they rely on historical probabilities to stay in the game and consistently seek profits.

Today the financial markets, like Molly, are also watching for the squirrel. In their case, the critter is a change in the Federal Reserve's stance on raising interest rates. They are watching to see whether the Fed will stay perched on its present branch, waiting and watching, or will it scamper up the tree to higher rates?

The difference is important. If the Fed waits too long, higher inflation could result. If it moves too quickly, it could strangle the economy's nascent recovery.

Long-time readers of this column know that I'm in the camp that believes the Fed is likely to err on the side of being too late rather than too early. That's been my position over the last two years, and throughout that period the timing of the Fed's tightening move has steadily been delayed. Last year at this time, other commentators were saying that rates would already have been increased by this time this year.

Somewhat ironically from the perspective of this week's column, this week's watch revolves around the removal of the word "patient" from the Fed's policy statement. But are the Fed and the markets being as patient as they should be?

Within a historical perspective, it is difficult to make a case for any change in policy even now. Historically, the Fed has changed policy and raised rates for either or both of two reasons: to slow an overheated economy or to slow inflation. Economic watchers will tell you that neither of these actions is appropriate at this time.

While we have had one decent increase in GDP, the following quarter it weakened. Unemployment has been reduced, but only at the cost of sending an unprecedented number of workers out of the labor force entirely. Residential building, which has been the lifeblood of past economic recoveries, has stalled for multiple quarters.

The other traditional indicator of a healthy economy is changes in retail sales. What the consumer is doing has always been deemed essential to determining the direction of our economy. Yet consumer watchers were shocked to see an expected increase in sales turn into another decrease last week. It was the third month of decreasing retail sales in a row, something that has only happened four times before.

Has the Fed ever raised rates in such an economic environment? I looked at the Fed Funds rate 3, 6, 9 and 12 months later for all four times when we have had three months in a row of declining retail sales. In every case for all four future periods rates were actually the same or lower! We are definitely in new territory when we are discussing a rate hike after economic numbers like these.

On the inflation front, there is no inflation-busting battle to be won. Both the Consumer Price Index and the Producer Price Index have actually registered declines in their last readings. A few years ago commentators were saying that the Fed's greatest fear was deflation. They could fight inflation, but deflation was much more difficult to deal with if the economy slipped into that cycle (witness Japan's twenty-year-plus battle to overcome it).

Proponents of Fed action will argue that today's deflation is simply the result of a rising Dollar and falling oil prices. The effect of a falling price in oil on the CPI and PPI is obvious, but it is likely to be short-lived. I talked with a friend from Houston the other day and he referenced his real estate agent who told of huge reductions in leased space in the oil patch. A look at the inventory of crude oil in the US confirms the fact that with record levels of oil on hand (the largest nine-week increase in oil inventory on record), rising oil prices are not likely to appear in the foreseeable future.

Source: Bespoke Investment Group

The rising Dollar's influence on inflation is not as obvious. Many Fed hawks are saying that the Dollar is outside of the Fed's providence. Its focus is employment and inflation. What does a rising Dollar have to do with those things?

Yet a rising Dollar affects both. It brings in cheaper imports that take business away from domestic producers. This can slow down the economy and hurt employment. And, as the chart shows, in the past, a rising Dollar has usually led to a declining Consumer Price Index, not the Fed's feared higher inflation.

Source: Bespoke Investment Group

So why are we watching the Fed for signs of an impending hike in rates? Only one argument makes any sense to me. The US and most of the developed world is stuck in a zero interest rate environment. The Fed Fund rate (the Fed's principal interest rate weapon) has been stuck near zero for some time, as have most short-term interest rates.

The Fed finds itself confined in a foxhole with no ammunition. It needs to be resupplied to deal with the next assault. It can only be resupplied by taking rates higher sooner or later. Which will it be? We wait for the squirrel to make its next move.

All the best,

Jerry

PS-In terms of stock prices, usually uncertainty brings lower prices. But the primary trend remains strong, our strategies are mostly invested, and some are even leveraged, while investor bullish expectations are weak (falling the most by one measure since January 2014-which turned out to be just before stocks rallied). Some investors have been concerned about last week's breach of the 50-day moving average, but historically that has actually led to higher-than-average gains in stock prices over the next week and month. So we remain moderately bullish, but expecting higher volatility in an uncertain Fed environment. It's good to have the computer programs … waiting and watching.