Friday, November 27, 2015

Investing is a Funny Business... AND... Your Weekly Update (video)

The Fed's readiness to raise its benchmark rate (make money more expensive) signals its members' optimistic view of the economy and, therefore, means good times are ahead for the U.S. stock market---or so goes the mantra of the ever-optimistic market pundit.

Makes sense, right? I mean if the economy is growing at a pace that warrants a little break-tapping by the Fed, business must be about to boom to ultimately a capacity-straining enough point where inflation (beyond some desirable level) becomes a legitimate concern. And---until inflation (at some undesirable level) rears its ugly head---booming business has to mean a booming stock market, right? Well, hmm...

Investing is a funny business. As you're about to read, doing what makes perfect sense all too often makes for uninspiring investment results. Let's start with commodities:

Three conversations come to mind: One, from a few years ago, with a client who informed me that he had been maintaining an online account where he would speculate at the behest of an old friend who happened to be an astute market-watcher/predictor. Another with a neighbor. And another with a guy who did a pest inspection for me last winter.

My client's friend would feed him tips that he'd implement in said account (apparently he had experienced enough winners to keep him engaged for the previous few years). For whatever reason, my client wasn't entirely comfortable with his friend's counsel in circa mid-2010: He wanted to know what I thought about going all commodities with his, let's call it gambling, money (his friend had assured him that the Fed's QE [which by then had become a household acronym] program would result in so much new money supply that inflation would run rampant and commodities would be far-and-away the best game in town). I explained that his friend was, on the surface, making a logical assumption, however, there was substantially more to be considered:

First of all, QE (the Fed buying treasuries and mortgage-backed securities from banks---i.e., placing billions of cash on bank balance sheets that could be lent into the economy), by itself, creates no inflation: The cash has to be put to use---at a pace that exceeds the economy's ability to produce compensating goods and services---to increase the rate of inflation. If all it does is sit on banks' balance sheets nothing---other than keeping interest rates very low---happens. Plus, you have to consider the supply of commodities in storage, the current rate of their production, and their demand in the global marketplace before coming to any conclusions as to where their near-term prices may be headed.

My neighbor, circa 2013, told me how he went heavy commodities, thinking that, yep, all that money printing had to lead to high inflation.

The pest inspector, in December 2014, after asking me what I do for a living, explained how he's been getting creamed in commodities---but remained certain that it was just a matter of time before he'd be able to cash in on huge profits.

I gave essentially the same lecture to the neighbor and the exterminator that I did my client.

With (I swear) no prodding from me, what remained of my client's online gambling account now rests in his portfolio with us, my neighbor has yet to again broach the subject, and I'm guessing, alas, that the determined exterminator has yet to exterminate his commodity positions.

Again, successful investing is all too often unintuitive. A point that I'll expound in the following, sticking with Fed policy as my backdrop:

What does it say about the economy when the Fed embarks on expansionary monetary policy? Well, it says that the economy is in trouble and the Fed feels it needs to make money really cheap so people will put it to use and rescue (expand) the economy. I.e., it means times are tough. And tough times are anything but synonymous with rising stock prices, right?

And, to reiterate paragraph two above, what does it say about the economy when the Fed embarks on restrictive monetary policy? Well, it says that the economy is robust enough to warrant the Fed making money more expensive in an effort to cool (restrict) the growth rate enough to keep the economy humming along at a non-too-inflationary pace. And robust times are indeed synonymous with rising stock prices, right?

Well, nope and nope! History, believe it or not, offers convincing evidence that one should expect strong market gains when the Fed signals that the economy is, well, weak, and weak gains (if not losses) when the Fed signals that the economy is strong.

Here's the proof:

In their excellent 2015 book Invest with the Fed, Robert Johnson, Gerald Jensen and Luis Garcia-Feijoo chart the performance of the S&P 500 from 1966 through 2013 during periods of expansive and restrictive monetary policy. As it turns out, stocks tend to perform spectacularly (average annual return of 15.2%) when the Fed signals that the economy needs major help, and scantily (average annual return of 5.9%) when the Fed signals that the economy's running hot. Hmm...

So how could that be? How could it be that stock prices, which by their nature are economically sensitive, rise faster when the Fed signals trouble, and slower (if at all) when the Fed signals economic growth? Actually, if we really stop and think about it, it's not all that unintuitive after all. You see when the Fed engages in expansive monetary policy it's pulling its levers to inject money into the economy. Astute investors---believing that more money means more capital (job producing) investment on the part of business and more spending on the part of consumers---bid stock prices (particularly those of companies in the cyclical sectors) higher in anticipation of greater profits down the road. Conversely, when the Fed engages in restrictive policy it's pulling liquidity out of the economy. Astute investors---believing that less money means less investment and less spending---then sell stocks (within the cyclical sectors) in anticipation of lower profits down the road.

Hence, we have the angst (I've been reporting on all year) about when the Fed is finally going to embark on a restrictive monetary policy. And, hence, you can understand why I'm not entirely on board with the popular notion that the market's just going to rally right through the first Fed rate hike. Although it just might---or at least not fall completely apart (which, at this juncture, would be my best guess)---if the Fed can convince astute investors that the glide path for rates going forward is going to be the flattest---or least steep---on record.

And, hence, you can understand why, for some time now---being that the European Central Bank is presently engaged in an aggressive QE campaign---I've been constructive on the stocks of Euro Zone companies.

Lastly, what about commodities? Shouldn't commodity prices do the same for all the same reasons? Well, you might think so, but no! In fact, they tend to do the opposite. Remember, inflation is the rising of the price of stuff. Commodities are stuff. When the Fed is engaged in expansive policy, it isn't the least bit worried about inflation. In fact it's signaling that their ain't any. When it's engaged in restrictive policy, it's reacting to the looming threat of inflation. And, typically, it's justified.

Here's the proof (that commodities tend to move opposite the broad market):

According to Johnson, Jensen and Garcia-Feijoo, the GSCI Commodity Index---which is comprised of 24 commodities within the energy, industrial metals, agriculture, livestock and precious metals sectors---has produced an average annual return of minus 0.19% during periods of expansive monetary policy (when inflation was the least of the Fed's worries) versus a whopping 17.66% during periods of restrictive policy (when inflation was at the top of the Fed's worry list).

Hence, you now understand why I've begun talking more about commodities as the Fed gets closer to lift off...

As for your weekly update, I'm thinking this week's TV segment should suffice:

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