Market Outlook: Fundamentals versus the QE II Distraction

There have been many recent reports about those waiting for a market pull back.  After all, we have seen two strong months and some investment and hedge fund managers may feel under-invested as year end approaches.  Those of us with new accounts have been looking for a good chance to buy, and feeling some frustration.  Is now the time?

Individual investors have mostly been paralyzed with fear.  The Age of the Internet has not served them well. The best stories, whether from mainstream media or blogs, are always about problems.

Today I would like to highlight two distinctly different approaches to thinking about your investments.  One of these looks to stock fundamentals and earnings.  The other focuses on headlines.

The Fundamentals

If you want to spend a very profitable five minutes, watch today's screencast from Abnormal Returns.

 

I especially like host Tadas Viskanta explaining that this is a contrarian story.  Tadas, who constructs his daily guide to the investment world after reading hundreds of articles, has a better take than anyone on the general tenor of commentary.  I strongly recommend that readers check out the links in the story.  I especially like the cited work of two of our featured sources --- why fundamentals make lousy TV and fourteen reasons that things are better than you think.

This is an especially good article because of the timing.  It is easy to write something "explaining" the day's market action and attempting to appear brilliant.  These stories comprise much of the guest list on financial TV.  It takes more courage and adds more value to go against the grain.

The Distraction

The ongoing "big story" features the Fed and QE II.  The story has all of the ingredients needed for feature treatment.

• Simplistic reasoning.  Since ordinary people do not understand central banking, fractional reserves, or money creation, it is easy to be a demagogue.  The phrase, "The Fed is printing money" is powerful and defies refutation.  For the average person, it signifies everything that is wrong.
• Political posturing.  It is easy to assemble a list of people who disagree with the Fed, including those from both extremes.  This is often a sign that policymakers are doing something right, but in this case people are just piling on.
• International intrigue.  Foreign countries are criticizing us.  President Obama has supposedly been weakened.

This has gotten so bad that the cartoon discussion on youtube has a million hits.  Amazing.  I wonder how many viewers are investors....  The good news?

Anyone who can read and think can get an investment edge.

What more could we ask?

The Key Point:  Separating what will happen from what should happen

I do not know whether QE II will "work."  I am much more confident about what the Fed will do.  Here are three fearless forecasts:

1. The Fed will be completely unmoved by foreign criticism.  This should be obvious.
2. The Fed will not react to partisan criticism.  This is also obvious.  I suppose there will be some great theater in the next two years.  Those who do not think we should have a central bank will make a big fuss in Congressional hearings.
3. Those choosing to "fight the Fed" with their investments will be big losers.

So much for what will happen.  For investment decisions, that is the most important part.  But we all like to understand what is going on.

Turning to what should happen, I understand that many readers are curious about the reasoning behind QE II.  I also know that the readership of "A Dash" is pretty sophisticated, including experienced investors and colleagues in the advisory business.  If you really want to understand what is going on, here are three excellent articles from leading sources:

Paul Kasriel, economist with Northern Trust.

Every student who took Econ 101 and stayed awake during the lectures learned that the Federal Reserve has the power to create credit figuratively “out of thin air.” The A-students also learned that the commercial banking system, not individual banks, under the fractional-reserve system that we and every other developed economy has also has the power to figuratively create credit out of thin air if the Federal Reserve first provides the “seed” money to do so. This is not unique to the Federal Reserve and the U.S. commercial banking system. This holds wherever there are central banks and fractional-reserve commercial banking systems.

Mark Thoma, University of Oregon economist, and the leading source of economic "pointers."  Read the entire article for a nice explanation of the policy options, with graphs.

Presently, the Fed cannot operate at the short end of the yield curve because the short-term rate the Fed generally targets –- the overnight federal funds rate — is at or very near zero. Operating at the short-end of the yield curve doesn’t do much good since those rates can’t come down any further. However, the Fed can still bring down rates at the long-end:

 

And finally, former Dallas Fed President Bob McTeer.  Of all the commentators, McTeer provides the most consistently accurate and pragmatic view.

I don’t quite get the logic of the “won’t-work-but-it-will-be- inflationary” point of view. If it won’t work to stimulate the economy, that presumably means it won’t stimulate spending. If that is so, how is it inflationary? If more bank reserve sit idle as excess reserves and aren’t used for lending, investing, and money creation, how is it supposed to tank the dollar? New (printed, if you insist) money must be spent on goods and services to drive their prices up; it must be spent on foreign exchange to drive the dollar down. If it isn’t spent, it doesn’t do good, or harm.

Say it won’t work. Or, say it will be inflationary. But don’t say both without explaining how that is supposed to work.

Conclusion

On the one hand, you can get your investment advice from cartoons and fight the Fed.

Or you can -- and should --  focus on fundamentals.

Comments

[oldprof]

Dal P -- You have it exactly. For investing purposes, it really does not matter whether we agree with Bernanke or not.

Thanks for joining in.

Jeff

[oldprof]

JohnF -- Nice to hear from you. My reference to "Don't fight the Fed" is not suggested as the reason to invest. It is intended only to emphasize that the Fed is bigger than you or me. Too many people disagree with Fed policy and therefore decide to ignore the likely effects. For some this has become a multi-year habit.

My reasons for liking the market relate to the rather obvious improvement in economic fundamentals, market valuation, and the continued growth in earnings.

I disagree about forward and backward earnings, but prefer to discuss that in the context of one of many (many) articles that actually introduce data showing why forward is better.

Meanwhile, I hope you prosper in your trading, and appreciate your comment.

Jeff

[Louis C]

True, and let's not forget the ever-shrinking money multiplier. A fractional reserve system only works when the multiplier effect actually has significance.

[Simit Patel]

It's inflationary because it causes a lack of faith in the US dollar, which causes a move out of the US dollar, which causes dollar-denominated prices to rise.

to elaborate, there are two types of price inflation:

1. demand-driven price inflation. customer A and customer B engage in a bidding war for Asset 123, driving prices up for Asset 123.

2. currency-induced price inflation. people move out of the currency, causing the currency to lose value, causing prices denominated in the weakening currency to rise.

[Dal P]

Jeff,
Very interesting and well-presented. The screencast from Abnormal Returns is especially good.

There are plenty of times where it is very complicated. This may be one of those rare gift times where it isn't.

I think it's currently advantageous to run with what the markets are giving us. Watch, absorb, and act - not the media, but the markets. Not what the markets should be doing, what the markets are doing. I'm not letting the financial media distort the view. Then, for me, it's an easy choice.

[johnf]

I think the "fighting the fed" phrase is most overused. Worse, it's a bad reason to invest in the stock market. While the market can react to more liquidity in the market place and rise, eventually the drugs wear off.

Sadly, the Fed's medicine is merely aimed at repairing the banks -- not job growth. This is the Japanese model and the result is known.

I don't see Fed intervention in the markets as savvy and it is not a making of a solid fundamental. This is obvious by recent past history...two bubbles in the last 15 years.

Furthermore, I personally prefer Shiller's 10 year smooth average of PE. This to me means stocks rate to offer low returns, combined with a low dividend yield.

I also tend to think of the future as one of low returns because of the mind shift in American consumer activity and the fact consumers remain highly levered: around 110%.

Thus, I see things as very cloudy with low returns. Any boisterous rallies -- if enjoyed -- should be sold to protect gains. Just one man's opinion.

[World economy update]

Most Americans have absolutely no idea how fragile the world financial system is right now. Once the rest of the world loses faith in the U.S. dollar and in U.S. Treasuries this entire thing could completely unravel very quickly.

The Federal Reserve is playing a very dangerous game. They are openly threatening the delicate balance of the world financial system.

[oldprof]

Mike C --Thanks. Fixed now.

Jeff

[Mike C]

The Kasriel link doesn't appear to be working.