Knee-Jerk Fed Reaction Doesn’t Add Up

August 22, 2012
By

The dominating factor in Wednesday’s trading was the release of the Federal Reserve minutes. Based on interpretation of the minutes, the Fed is closer to pulling the easing trigger than might have been anticipated.

Here is the money paragraph (via BI):

 “A number of them indicated that additional accommodation could help foster a more rapid improvement in labor market conditions in an environment in which price pressures were likely to be subdued. Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.

You can see the real time reaction via 5-minute charts for the euro (EURUSD) and Japanese yen (USDJPY).

EURUSD surged higher on the Fed minutes, and USDJPY tanked, reflecting immediate weakness in the dollar in both cases as the probability of near-term easing was adjusted upward. Silver, gold and gold stocks also surged on the minutes specifically.

So if you’ve ever wondered if the Fed can really move markets, the answer is yes, Virginia, it can. The Fed can move markets without even actually doing anything… via the mere shadow of a hint of a possibility that the Fed’s central bankers are in an easing state of mind. (That sounds like a bad country song.)

It seems ridiculous at this late date for efficient market theory to still exist. But it does. And yet, despite the dogged insistence of some academic economists that markets are ‘rational,’ we can see plainly that markets are often not rational at all. (Sometimes they are rational… and sometimes they are not… but that is the whole point as to why investing and trading opportunities exist, and why efficient market theory as aggressively stated is a load of garbage.)

Keep in mind the following points:

  • The dovish Fed minutes came out prior to the release of more constructive U.S. econ data
  • The Fed has logical reason to avoid acting prior to the November elections, if at all possible
  • The Fed is constrained politically (though not operationally), and only has so many “bullets”
  • It seems illogical for the Fed to shoot here and now, vs. saving its bullets for later

Further keep in mind that, by recording a bullish response now, the market has essentially doubled down on positive affirmation expectations from Fed Chairman Bernanke’s upcoming Jackson Hole speech.

In other words, Bernanke is giving a major speech on the 31st (the Friday after next). The stock market baby will want its lollipop, and if the speech does not deliver, there will be greater potential for dashed expectation than before via this pre-emptive optimism.

It really doesn’t make a whole lot of sense this time:

Politically, the Fed is better off waiting until after the elections (or at least closer in) to act. The earlier the Fed acts, the more political risk the Fed creates in terms of a hostile / accusatory environment in Washington. Picture the scenario where the Fed stimulates early, Republicans accuse the Fed of partisan action (in wanting to help the sitting president), and then Romney / Ryan win. This is a real risk to acting early, and the Fed is politically savvy. Why would they take that risk unnecessarily?

Psychologically, the Fed is better off waiting for a new mini-crisis, or at least a meaningful decline, to pull a new stimulus trigger. In past instances, stock market declines have been halted and reversed by announcements of central bank action. The same goes for various mini-crises out of Europe etcetera. So why would the Fed act early, before there is any decline or mini-crisis present, instead of waiting until after the next one occurs?

The Fed is aware that, after QE3, QE4 will become  a much tougher sell. And so, again, why would they be inclined to act prematurely just because there are a bunch of doves cooing in the meeting minutes?

The logic of expecting near-term stimulus, with U.S. econ data slowly getting better and Europe firming up, even as the market hovers near multi-year highs, with a politically sensitive election date looming, just doesn’t make sense. Wednesday’s response to the Fed minutes feels like an ill-thought, knee-jerk type reaction.

Further note that, while precious metals rose enthusiastically in response to the minutes, treasuries (IEF, TLT) did not back off. What is this telling us? And does the prospect of Fed easing change anything in respect to the gloomy trajectory of up and coming corporate earnings in the first place? No, not really…

It is hard to understand, in fact, why long-term investors are even fans of quantitative easing in the first place. (Not all of them are – David Einhorn has gone on the record as against QE).

But for those long-term investors who cheer the prospect of stimulus – what in the world are you thinking?

It is easy to understand the attraction of QE for some parties, from both a trading perspective and a Wall Street perspective:

From a trading perspective, it is better for markets to move than stand still… And QE makes markets go up, at least in the near term. Traders can get in, “ride the false trend” as Soros would advise, and then get the hell out, or better yet go short, when the faux optimism crumbles.

From a Wall Street perspective, there is money to be made via stimulus… the hype-and-hope engine must simply be kept churning, and so whatever accomplishes that aim is good. Wall Street itself is driven by fees, deals, and otherwise useless or non-helpful activity that ensures the middlemen get their cut – therefore anything that artificially fuels investor activity puts money in Wall Street’s pockets.

But for the individual investor, stimulus is a disaster that ultimately costs them money! As mentioned, David Einhorn of Greenlight Capital has made an excellent case as to why stimulus is bad for investors, and actually bad for stock valuations. But not only do QE3 prospects muck up valuations in the big scheme of things, they set up long-term investors to be knocked over like bowling pins, by getting them to respond to false price and valuation signals at the worst possible time, before getting the rug pulled out from under them!

Long term investing is about paying a good price, or at least a fair price, for value and/or growth. It is about purchasing discounted streams of cash flow, and holding on to those streams for a long period of time.

What investing is NOT about is anything that falls under a three month time frame. If you regularly hold your positions for days or weeks, then you are primarily a trader, not an investor.

There is nothing wrong with the above – we are traders through and through. As such, stimulus hope jags give us the chance to buy or sell fairly quickly, profiting on ‘rips and dips’ and then getting out (or turning short).

But what in the world does stimulus do for any kind of true long-term investor perspective?

There is very reasonable probability that, for all the gains Wall Street has handed long-term investors in this ‘hoping for stimulus’ phase, all will be taken back — and then some — when the hope jag run collapses.

And a turning tide of angry and disappointed expectations could materialize soon, given how blatantly illogical today’s response was, to some Fed minutes that were old news (from an economic data point perspective) by the time they hit the tape.

Mr. Market can be a real dumbass sometimes. As mentioned, this can be great for nimble traders with the ability to rapidly dial up, dial down, or even completely flip net exposure levels, as we readily do in the Mercenary Live Feed. But yours truly is honestly scratching his head as to why long-term investors, who get the short end of the stick, sanction and even applaud these dumb Fed games.

NEWS FLOW

How much longer can China bulls rely on “stimulus” as a magic elixir to lift all flagging prices? Some weeks ago it was reported that China is loaded down with so much copper, concrete floors in warehouses are buckling under the strain. China’s trillions in reserves, meanwhile, are no guaranteed answer to local crisis.

Accumulating evidence suggests global slowdown is real, and no emerging economy in all of history has made a successful multi-decade transition to prosperity without experiencing at least one crisis (and likely more). You can include America in that group too – look what the USA went through in the first half of the 20th century.

Base metals seem a terrible bet at this point, and “China stimulus” a laughably tired and false hope.

Speaking of false hopes – what are the odds of Fed Chairman Bernanke being “market accomodative” in his upcoming Jackson Hole speech on August 31st? The Federal Reserve is not constrained operationally, but they are constrained politically and psychologically. So why would the Fed Chairman waste precious bullets supporting a market near multi-year highs, when more serious troubles – and better timing to use precious ammo – lie dead ahead?

Similarly, the late summer bulls are in pleasant denial as to the bright red flashing warning sign that is the corporate earnings outlook. Deteriorating top line revenue is a precursor to shrinking bottom line profit margins. Worse still, a revenue contraction followed by profit contraction is consistent with the cost-cutting narrative: In addition to the powerful driver of initial 2009 stimulus coming off a panic-low base, U.S. corporations increased profits substantially by cutting costs and trimming excess fat.

That efficiency boost represents a form of one-time gain with a long-term cost – to the degree that U.S. companies beefed up their profit margins by firing workers andcontributing to structural unemployment, they sowed the seeds of future revenue decline, and thus profit decline. We are seeing the ‘green shoots’ (brown shoots? rotten shoots?) of such a strategy beginning to pop up now.

The housing market remains a positive, with all of Wall Street convinced that the rebound is real. We harbor some remaining skepticism, though, mainly because of the mass participation of the investment industry. When every money manager who can scrape the capital together is out looking to buy single-family home inventory in bulk, of course you are going to see a pop in the numbers. But does this really change the longer-term picture?

When Asia on the whole experiences another severe financial crisis, many in the financial media will likely refer to it as a “black swan.” But in reality, it will hardly even qualify as a gray swan. The warning signs are just too obvious for those paying attention…

The “widowmaker” (i.e. short Japan trade) claims another victim. At a 61% depreciation rate over a timespan of less than 36 months, will Bass’ funds last long enough to be proven right? This is the trouble with negative carry bets oriented to macro crisis, and one of the reasons why small bets and small losses — waiting to scale up until the inflection point clearly reveals itself — are far preferable. (But you have to be a good trader, and have a trading-oriented shop, to make that style work. Again, that is what we do.)

YAWN…

How long will it be before America’s wasteful food habits, combined with a criminally insane ethanol policy, starts getting the U.S.A. labeled as cruel, murderous even, for destroying untold amounts of food even as large portions of the planet starve?

If Jeremy Grantham is right, an escalation of the food problem – and the bottom rungs of the developing world facing starvation as grain exporting countries shut down exports – is just a matter of time.

CHART NOTES

  • Immediate USD weakness on release of dovish Fed minutes
  • Major indices rebound, though small caps remained weak
  • Multi-year highs still critical resistance area for DIA, SPY
  • Semiconductors (SMH), others losing leadership
  • Precious metals (GLD, SLV, GDX) gaining leadership
  • Copper, base metals strong surge
  • Treasuries (TLT, IEF) strongly rebounding
  • Multiple Dow components surprisingly weak (HPQ, ouch)
  • Rotation into “dove” instruments prone to disappointment?
  • Another washout ahead if Jackson Hole disappoints?

JS (jack@mercenarytrader.com)

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