Countless times in my career I’ve heard “If there’s one thing the stock market dislikes, it’s uncertainty.” Although I do believe this to be true, I also believe there’s one thing the Federal Reserve and Politicians dislike even more; being the scapegoat for the masses.
That’s why despite “uncertainty” over Federal Reserve policy and a looming US Debt default, the Markets (DCM included) made solid bets that business would continue as usual over the past month. Business this year has been built on stock buying that has resulted in all-time highs in the Dow and S&P seemingly every month.
However, these records have been built on record mutual fund inflows and margin levels also at historic levels. A fact that has been a cause for alarm for many prominent Fund Managers and economists around the world. We think there’s good reason for the concern, referring back to our July comments “Leverage incites panic without fail when the music stops playing.” We have seen bits of this in the highly unusual Hot and then Cold streaks experienced this year. Particularly in buying streaks characterized by nary a pullback often for weeks at a time.
Despite our accurate prediction of vague Federal Reserve policy going forward, the broader stock market is determined to push higher. As alluded to above, at this stage of the game/experiment, the Federal Reserve has painted itself into a corner of increasingly fewer and fewer options. Future Policy options appear to be limited, unless The Fed is willing to take the heat that would come if it were to pull the monetary stimulus rug out from under an economy it has been supporting for the last 6 years. That coupled with the imminent appointment of a new Reserve Chairman that by all accounts will be as supportive if not more so than Bernanke and a “Real Growth” economy that is dismal at best. We ask; how muddy could the Fed really make the waters?
Borrowing an idea from Pimco’s Bill Gross, we suggest if the Fed really wanted to cool the markets, they could simply increase Margin Requirements. With current Margin levels at record highs, simply requiring more capital on deposit would quickly bring the boil down to a simmer. Essentially the same thing was accomplished in housing when 30 year mortgage rates jumped off historically low levels to two year highs. We however, find this outcome highly improbable, as the Fed’s only verifiable success in their great experiment can be found in rising equity and rising home prices, both of which admittedly, have resulted in some watered down job creation.
More likely, the Federal Reserve is hoping that the market will contain itself as high prices tend to cure high prices. With many respected analysts in our industry describing the Market as entering bubble territory, the Fed may be right. At DCM we will lean towards higher prices beget higher prices until the trend has turned, which clearly has not occurred yet. We tend to prefer tapered down, low-risk longs. Particularly when entered after nice pullbacks from recent highs. At least until there is clear evidence of a trend turn. So where do we go from here?
It is extremely difficult to ascertain the outcome of all of the Federal Reserve’s efforts and for that reason our investment outlook will look very similar to last quarter. As predicted in our previous outlook, a variety of Markets tempered down their trajectories, with Gold, Crude Oil and 10 year notes all virtually unchanged since our last commentary. The Stock Market of course, continued to keep pace with the years previous gains. With little changed from an economic standpoint, we’d be inclined to continue to ride any support provided by the Fed, but with the strong suggestion that one remain even more nimble than previously suggested as more and more institutional investors continue to pay higher and higher prices and thus receive lower and lower yields, with greater and greater risk.
Hopefully, the “Speculative” liquidity led market will give way to the “Real Growth and Productivity” economy in some sort of smooth transition. Unfortunately, the US economy has become addicted to easy money and quick returns that have recently been found in stocks and housing. The adjustment to a slower production based economy will be a difficult one. One glimmer of hope can be found by the fact that more and more respected economists seem to be calling for just this adjustment to occur.
Regardless of the longer-term outlook, we remain confident we can lead you in the right direction. Our outlook for this quarter looks similar to last quarter with more emphasis on caution:
- Avoid fixed income particularly long-term bonds
- DO NOT FIGHT THE FED
- Have exposure to physical assets in addition to equities
- Maintain a nimble portfolio, as volatility will likely increase as will risk as asset prices increase. Taper down long-term positions and look for retracements.
Despite the Feds relatively successful efforts to muddy the waters in regards to the future of QE, one fact seems to be overlooked; the Fed is not raising interest rates in the near future. Therefore, cheap money will still be widely available and most risk assets attractive. Keep in mind that even in muddy waters, one can still navigate successfully, albeit a bit more carefully. Besides, more often than not, it’s the dangers most aren’t looking for that derail the markets. Perhaps the Markets own overvaluation should be more concerning than whether or not the Fed Tapers QE.