The First Law
Oddly enough, after what I can only describe as one of the most interesting quarters of market behavior in memory, I sit here pondering the 1st Law of thermodynamics;
“The law of conservation of energy states that the total energy of an isolated system is constant; energy can be transformed from one form to another, but cannot be created or destroyed.”
You might find basic physics principles an odd concern in the wake of a meteoric rise in interest rates (60%), unseen in US history. Couple that behavior with the near 160 point S&P market rally, followed by a near 130 point break, followed by the current 140 point rally, it might seem downright loony to be concerned with the principle of energy conservation.
I, however, would argue that this simple and constant certainty is absolutely pertinent to the behavior of today’s markets. In fact, I wonder if Chairman Bernanke with his truly stunning educational background (including a Bachelor’s degree in Economics and a PhD in Philosophy in Economics from MIT) was required to take a simple entry-level physics course. For the purposes of this discussion, I will assume with his 1590 out of 1600 on the SAT as a teenager, that he is at least somewhat familiar with the concept.
If that is the case, then the Chairman is also aware that he cannot create growth out of thin air. The Fed has a limited toolbox with which to work, and that toolbox does not include a magic growth potion. What it does include is the ability to set the Federal Funds rate and the ability to buy and theoretically sell various assets from its balance sheet. In essence, although the Fed cannot create growth, perhaps it can transform the potential growth lying in cash reserves of the conservative into real growth by convincing the economic powers that be to take risk in the form of investment into R&D and productive capacity.
It would appear that the theory of not only our own Fed, but also of the majority of central banks around the world is that buoying asset prices will in fact catalyze some change in sentiment and ultimately transform that potential energy into real growth.
However, referring to our last quarterly update, “Money will inevitably flow into the only places it can find yield, not production and innovation, because these take years to foster, but liquid assets of all shapes and sizes. Ever wonder why Stocks are at record highs despite unemployment at unusually high levels?”
In our opinion, production and innovation are real growth, not stock and housing prices. It would appear we are not alone in this opinion, quoting PIMCO’s Bill Gross’ June outlook “When ROI’s or carry in the real economy are too low, corporations resort to financial engineering as opposed to R&D and productive investment.”
Indeed the Chairman himself has admitted as much, and we presume that was much of the reason for his somewhat baffling comments that catalyzed the rise in rates and the temporary plummeting of stocks in early May. If only his efforts to stimulate real growth were as effective. With that said, the 10 year note rising 60% from its lows in roughly a month must have been a startling preview of what could come for the Chairman. This probably led to the biggest act of back-peddling we have seen in Mr. Bernanke’s term as Fed Chairman. How quickly the Chairman described the Market as one of slow but steady improvement, to one that is nowhere near being taken off life support.
Make no mistake: the Fed Chairman is no fool. His comments both before and after the rate rise were articulate and well thought out. We believe the Fed became all too aware that it has been telegraphing policies far too clearly. Albeit in their effort to stimulate real growth, the Fed needed to be as transparent as possible to engender confidence.
The problem with too much transparency is that there appears to be what Diversified Capital Management would describe as two subset economies; one of Real Growth and Productivity and one of Speculation, Liquidity and Leverage. While the real growth economy needs clarity, too much clarity for a leveraged, speculative market is tantamount to rehabbing a meth addict with unlimited supplies of meth. As a reminder, Research and Development takes years to create, whereas large investment funds can invest and unwind Billions in dollars of positions very quickly.
What the world and the Chairman saw in May is that too much telegraphing results in mass liquidation of large positions simultaneously at any sign of policy change. Fueling the fire are excessively low yield spreads (a product of Fed policy) that have caused these same investors to pay even higher and higher prices with even more and more leverage for less and less return. The bottom line is as the game comes to a close, leverage tends to incite panic.
So what next? We expect the Fed to become somewhat more vague on policy over the coming months, with an emphasis on the long-term weakness of the economy while simultaneously citing the caveat that they could increase or decrease asset purchases at any time as the economy dictates. What does this mean for the Markets? The Fed hopes it creates enough uncertainty to prevent misallocation of assets and the bubbles that follow, while simultaneously maintaining at least the slow, lack luster growth of the past 5 years. We hope so too.
Unfortunately, the thin rope of hope seems to be unwinding. Going forward we believe again that a nimble portfolio is best suited for this market. With an expectedly less transparent Fed, perhaps the Market will again trade both sides, rather than the absurd one directional moves of late. We maintain our same investment outlook for this quarter as last quarter, with one expectation; as alluded above, that the market will need to rebalance for the massive move in interest rates, housing prices and equity prices. Perhaps not significant retracements, but rather a calming of the seas.
- 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 with the expansion of monetary supplies. Have an exit strategy for all long-term investments.
- Look for significant rebalancing over the next quarter as out of balance markets rarely stay that way.
In conclusion, much like the 1st Law of Thermodynamics in which energy can be neither created nor destroyed, only transformed from one form to another, the energy to create real economic growth cannot be created nor destroyed. The real question is whether or not the Federal Reserve can catalyze a reaction from our economy that will result in the growth everyone desires.
Thus far, there is no clear answer to this question. However, after the rise in U.S. Treasury yields, the market should be concerned. If, in fact, the Fed loses its grip on the ultra-expensive U.S. treasury market, we will have our answer. The Fed is certainly aware of this fact and for this reason alone, don’t expect tapering anytime soon. Thus, we expect a fairly stable 3rd quarter in which DCM can lead you in the right direction.