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September 24, 2009

Don't fight the Fed

The first stock market saying I ever remember learning was "Don't fight the Fed." The professor in my first college investments course was explaining the importance of the Federal Reserve's monetary policy decisions on the stock market's direction. He walked us through some prominent patterns (each with it's own pithy saying) like "three steps and a stumble" — the tendency for the market to fall after the Fed raises interest rates for a third consecutive time — and why those relationships existed. Some of these specific patterns aren't as widely known anymore (perhaps because the Fed started changing its Fed Funds interest rate more often over the past two decades?). But the main idea was that if you wanted to succeed in the stock market, you had to know what the Fed was doing and position yourself accordingly.

This came to mind today while reading Jon Markman's latest article. In it, he describes the impact that he expects the massive stimulus efforts of the US government (along with virtually every other world government) to have on the stock market. In his view, this massive unloading of the monetary cannons trumps every other factor when evaluating the likely direction of stocks for the next few years. His opinion is we're witnessing a replay of 1991. Terrible economy, significant financial duress (S&L crisis), and the birthing of a massive bull market in equities. In other words, don't fight the Fed.

Picture this: At least $10 trillion has been created and poured into the world's financial arteries in a process that will take at least three years to seep out through various government spending programs. And if bearish skeptics don't understand the impact that money will have, it's mostly because they've never seen something that big before and it's frankly almost unimaginable. "People don't see it because monetary infusion cycles don't happen very often, and certainly not on this scale," [veteran money manager Robert] Drach said. ...
"The main thing is not to be frightened of the market," Drach said. "People who get hurt will be ravaged by low returns in Treasurys. They will be annihilated. It will look to them as if the whole episode is a money-transfer system from senior citizens and foreign investors buying U.S. government bonds to young people buying stocks. But it won't have to be that way for anyone. Everyone should participate in equities if they can. It will be a rare opportunity to grow wealth."

So get ready to party like it's 1991. If sector rotation becomes key, then the game will be played at the level where we must figure out which groups are faltering and which ones are about to take their place.

It's an interesting premise, and worth a quick read of the whole thing to see how he draws the parallels between the early 90s and today.

Is it plausible? Hard to know. But it is surprising to me that so few people seem to have focused on the potentially positive implications this huge wave of liquidity has for the market. Those that mention it at all seem to view it in exclusively negative terms, as in "this market rebound has been artificially inflated by all the stimulus...just wait until that runs out and the market crashes again."

Ultimately, the insane borrowing and spending the government is doing has to come home to roost, or else the government would just do this every time the market needed a boost (some would argue that's pretty much exactly has happened during the past 25 years). But the timing of those cause-and-effect relationships can be much more protracted than anyone would expect.

A final thought: if this does turn out to be remotely accurate, note the last comment I excerpted above. "If sector rotation becomes key, then the game will be played at the level where we must figure out which groups are faltering and which ones are about to take their place." That's a pretty good explanation of what SMI's Upgrading strategy does. Good to know we'll be well prepared...