Category: don’t fight the Fed





1.  fear of irrational Fed easing doing irreparable harm to a rational short selling strategy

They’re back!

Don’t look now, but those masters of the universe who arrogantly whistled past the greatest credit bubble and bust in history are again gracing the covers of popular business magazines. For example, the October 12 issue of Barron’s featured none other than Bill Miller “riding high again as one of America’s top fund managers.” Yes this is the same Miller who beat the S&P 500 15 years running, was named “Fund Manager of the Decade” by in 1999, and anointed “greatest money manager of our time” by Fortune in November, 2006.

To say Bill Miller didn’t see the financial train wreck of 2007-2008 coming is an epic understatement. For the 18-month period ended this March, his Legg Mason Value Trust lost 72%, wiping out a decade of gains. When the first subprime cracks appeared in March, 2007 he thought Countrywide Financial would be a long-term beneficiary. When the Fed began easing August 17, 2007 he chose not to fight the Fed:

“We bought financials after the Fed [first] injected liquidity. That’s what you do in a liquidity crisis… This turned out to be a collateral-driven crisis caused by underperforming debt… We’ve analyzed that mistake and tried to make adjustments to risk management and the portfolio-construction process.”

Besides Countrywide, his fund’s investors were buried in Bear Stearns, Lehman Holdings, Fannie Mae, and Freddie Mac. He even had the audacity to blame the government for his mistakes:

“Lehman was investment-grade Friday and worthless short-term paper on Monday,” Sept. 15, 2008, Miller notes. Miller blames the feds for the Lehman debacle, saying their “pre-emptive seizure” of Fannie Mae, another ill-fated Value Trust position, and Freddie Mac caused the other financial dominoes to fall. “It was a gratuitous wiping out of equity capital,” says Miller, referring to the preferred shares issued by the mortgage giants as their troubles grew. The government, he adds, “told them to sell capital.” He bought the stock because they both met capital requirements and Fannie had been bailed out once before. “I expected forbearance like in the early 1980s, but they didn’t do it this time.”

Like at least 90% of those in the investment industry, Bill Miller expects – no, demands – that government to step in and backstop his risk taking. When the feds are powerless to do so and overwhelmed by market forces, he whines like a baby. When he rides a wave of artificial stimulus (Value Trust is +37% year-to-date) he attributes his oversized gains solely to his guts and acumen.

What does Miller like now? More than 25% of his portfolio was in financials as of June 30, 2009 and positions included State Street, NYSE Euronext, and Goldman Sachs.

Bear markets do not end until behavior changes and the necessary lessons are taught. By all appearances, this process has been subverted by trillions of dollars in bailouts, stimulus, credit backstops, and injections of liquidity. Old habits die hard…, i.e., the secular bear is still a cub.

Goldman’s secret sauce?

The October 5 issue of Grant’s Interest Rate Observer had this interesting tidbit about Goldman Sachs, et al.:

How is it, Jim Chanos had asked, that the big broker-dealers can show consistently high returns on equity when their own star alumni, once transplanted at hedge funds, so often struggle to earn a half or a third of what their alma maters manage to produce, “no matter how leveraged they are or what bets they have on?”

There seems to be a remarkable difference between the public and private sides of Goldman Sachs. Very bright people work in both, yet the results of the former are mediocre while the latter are stellar, bordering on statistically improbable. Is it possible that their secret sauce is friends in high places and an opacity that allows them to trade on inside information? And does the SEC enforcement of insider trading laws for the rest of us give them a further unfair advantage?

If our hypothesis is correct, Goldman’s private investment/trading strategy amounts to “don’t fight the Fed” with the advantage of knowing the Fed’s next move(s). Such a strategy worked to maximum benefit in August and September. It will become less effective as the credit drug wears off. In fact, during a bursting bubble (a likely scenario) the best strategy is “fight the Fed.” In that event, Goldman’s goose would be cooked, regardless of how many friends it has in high places. Echoes of Enron?

Study says don’t fight the Fed

Last Friday, John Waggoner, in a USA Today article, “Rate cut could skew investing path toward stocks, gold,” re-hashed the nearly universally accepted wisdom “don’t fight the Fed.”

Credit expansion, the opposite of a crunch, is good for stocks. When the Federal Reserve pumps money into the financial system, it makes more money available to lend, driving rates down. Lower interest rates stimulate the economy, lower companies’ cost of borrowing and make stocks look more attractive in comparison with bonds and bank CDs.

Waggoner cited a study by a group that represents certified financial analysts:

A recent study by the CFA Institute found that tweaking your investments according to the Fed’s monetary policy can be highly beneficial. The stock market averaged a 12% annual return from 1973 through 2005. When the Fed has pursued an expansive monetary policy and lowered short-term interest rates, the stock market gained an average 17.41% a year. When the Fed was raising rates, the stock market gained an average of only 5.34% a year.

The other lesson, buy cyclicals:

You could have substantially improved your record by investing in the correct sectors. Analysts have long divided the market into cyclical stocks and non-cyclical stocks. Cyclical stocks fare well during an economic expansion. Non-cyclical stocks, such as health care, tend to hold up well when the economy is faltering.

The study found that cyclical stocks gained an average of 20.27% a year when the Fed was lowering interest rates. When the Fed raised interest rates, cyclical stocks gained just 2.25%.

My comments:

  1. Long cyclical stocks (materials, tech, industrials, energy) is a crowded trade.
  2. After at least 25 years of “successful” crisis intervention, the mainstream financial community is convinced the Fed is omnipotent.
  3. It is not.

NYU economics professor puts faith in the Fed

“The current problem is not so much a stock market problem as it is a credit problem, and what we’re seeing in stocks is just a reaction to it,” said Richard Sylla, professor of economics and financial history at New York University’s Stern School of Business. “I don’t think it’ll be so bad since the Federal Reserve is prepared to provide the liquidity to let the market stabilize.”

Sylla said the Federal Reserve has had 28 years of good leadership and exhibits a much better understanding of history and how credit and the financial markets operate.

The above was from an article on titled, “What history tells us about market slumps.” Author Andrew Leckey’s conclusion:

So now we know the lesson: History shows it makes the most sense to stay put with your investments. Yet human beings aren’t always sensible.

My comment: Wrong history lesson, wrong economics textbook.

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