If there is one piece of advice investors believe in, it’s “Don’t fight the Fed.” Well, maybe. Despite the “come-on” title of this post, however, my topic today isn’t precisely “fighting the Fed,” but more like “How to beat the Fed at its own game.”
Suppose we lived in an authoritarian society where government mandarins controlled the stock markets. Oh – wait! – we do live in such a society. The only difference, as far as I can see, is that in an authoritarian society the mandarins control the stock market for selfish or malignant reasons (getting rich, making their friends rich, punishing their enemies) while in American society the mandarins control the stock market for purportedly benign reasons: to accelerate or retard economic growth, employment and inflation.
But if you’re an investor, you don’t much care why the mandarins are manipulating the markets, you only care that they’re doing it. And, of course, what you should be doing about it.
Way back in 1996, then Fed Chairman Alan Greenspan famously worried, “how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?”(1)
Greenspan turned out to be wrong – or, as he would undoubtedly prefer to view it, “early” – as the stock market Bull continued to bellow for more than three years. Indeed, investors who ignored Greenspan and simply held onto their stocks did exceptionally well, right up to the present time (although it was, now and then, a wild ride). This suggests both the benefit of a buy-and-hold strategy and also the benefit of keeping firmly in mind that the academic economists at the Fed have no clue about the stock market.
Fast-forward to present times and we find ourselves entertained by the specter of Janet “Suckerpunch” Yellen swinging into action, announcing that, broadly speaking, market prices are fair, but that certain segments are too high, namely Social Media, biotechs and junk bonds. Bingo, billions of dollars of investor value went into the *&!#can.(2) Was Yellen right? Who knows? The difference between good investors and Fed chairpersons is that good investors don’t think they know more than the market.(3)
But since the Fed is determined to manipulate the stock market, how can investors beat them at their own game? In late 2008, the Fed began expanding its balance sheet by buying mortgage-backed securities without sterilizing those holdings by selling other assets (QE1). In November of 2010 the Fed began buying Treasury securities (QE2) and in September of 2012 the Fed began an open-ended purchase of $40 billion of agency mortgage-backeds (QE-Infinity). The Fed was transparent that its aim was to pump up the values of risk assets by making unrisky assets very expensive to own.(4)
If we’d been as smart then as we are now, how might we have successfully fought the Fed? Before we answer that question, let’s talk about what we actually did during all those QEs. What we actually did is, we kept our exposure to risk assets more or less at target (higher in US large cap, lower in US small and EAFE), but we implemented that strategy through managers and tactics that were on the conservative side. I.e., we didn’t buy cap-weighted index funds (a momentum strategy) or hire go-go gunslinger-type managers(5) and we gradually lightened up on junk bonds.
In other words, we weren’t about to fight-the-Fed by going to cash or – AACK! – actually shorting the market. On the other hand, we feared that a policy mistake or an unforeseen geopolitical event could be devastating, given how high – and, hence, vulnerable – markets had been pushed. That strategy has produced extremely good returns on an absolute basis, but it has trailed momentum products like index funds.
What we could have done, given how smart we are now, is to have adopted a two-pronged approach:
- Prong 1 would be based on the premise that if the Fed wants to pump up risk asset prices, the Fed is damned well going to pump them up. The way to beat the Fed at its own game is to adopt the most aggressive portfolio strategy you can stand and then lever it up, say, 20%. If you had done this, you would now be very rich.
- Prong 2 would be based on the fact that the Fed knows nothing about the stock market and, therefore, sooner or later, will blow it Big Time. The way to beat the Fed at this game is to use some of the riches you made on Prong 1 and buy portfolio and sector hedges, so that when the end comes, you’re covered.(6)
Of course, we can’t go back in time and implement Prong 1 and Prong 2, but we could certainly implement them now. Should we?
Alas, it’s too late. The Fed’s QE adventure is coming to an end this fall, and while Dr. Yellen continues to claim the Fed will keep interest rates low practically forever, it’s safe to assume she’ll soon be singing a different tune. Already the regional Fed banks are screaming for easing to stop. Already unemployment is virtually at the Fed’s target (it’s at 6.1%, versus a target of 5% to 6%). Already there are pockets of wage pressure and inflation.(7) On top of this, the Bank of England is likely to raise interest rates by the end of the year, leaving only the European Central Bank and the Bank of Japan hanging out there, twisting slowly, slowly in the wind.
In recognition of this, the most overvalued sectors are already beginning to correct – especially small caps and junk – and we can expect that to continue. We can also expect a transition back to the US dollar (and the pound sterling), weakening the euro and the yen. Shortly after that, we can expect that equity investors broadly will wake up some morning and realize that the terrific economy priced into stock prices isn’t happening. Oops.
So, yes, it’s too late to beat the Fed at its own game by leveraging up and hedging at the same time. But it’s not to late to beat the Fed at its own game by lightening up on risky assets before everybody else does.
(1) “The Challenge of Central Banking in a Democratic Society,” speech to the American Enterprise Institute, 12/5/96.
(2) Twitter promptly fell 1.3% and Facebook fell 1.7%. Biotechs dropped 3.5% and junk spreads widened by the most since the last Fed jawboning exercise, Bernanke’s “taper tantrum” of 2013.
(3) For what it’s worth, I agree with Dr. Yellen about overvaluations in these sectors. However, Dr. Yellen forgot to mention that if Social Media stocks, junk bonds and biotechs were in fact way overvalued, they were only way overvalued because Dr. Yellen’s policies had been pumping them up for a very long time.
(4) That is to say, if the Fed could drive returns on bonds well below inflation, anyone owning bonds would inevitably get a little poorer everyday in real terms.
(5) Of course you remember the “gunslinger” portfolio managers from the 1960s, typified by folks like Fred Alger.
(6) Despite preposterously and persistently low vol, simply buying insurance via put options would have been very expensive. Less expensive insurance could have been had by using interest rate swaps to benefit from a classic flight-to-quality (i.e., to US Treasuries), buying call options on equity vol, or using credit default swaps designed to benefit in the event that corporate bond prices fell.
(7) According to the Bureau of Labor Statistics, average hourly wages rose 1.3% in 2012, but already in mid-year 2014 wages have risen 2.4%. While that’s still a relatively slow rise, it’s nearly double what we saw a few years ago.
Next up: Maybe We Should Be Afraid
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