Tickle Me Elmo and the Fed AND Your weekly update...

So it's all but guaranteed that, come December 16th, the Fed (short for the Federal Open Market Committee, or FOMC) will raise its target range---from 0.00-0.25% to 0.25-0.50%---for the interest banks pay one another for the short-term borrowing of the reserves they maintain at the Federal Reserve. Hmm... seems pretty benign don't ya think? If so, then why all the hullabaloo?

Well, let's consider what the Fed actually has to do to get that benchmark rate off of zero.

You might be thinking that Janet Yellen and crew control the Fed funds rate by simply telling banks how much to charge each other. Nope, not that simple. You see, money is essentially a commodity and, like other commodities, the law of supply and demand dictates its price. But whereas the supply of most other commodities is influenced by demand in the marketplace, the supply of money (that banks hold on their balance sheets) is influenced by the Fed's desire to influence demand in the marketplace.

The Fed is kinda like the Organization of Petroleum Exporting Countries (OPEC). OPEC has its members who influence the price of oil by controlling its supply. The Fed has its members who influence the cost of money by controlling its supply. When OPEC wants the price of oil to rise, it lowers the available supply. When the Fed wants the price of money to rise, it lowers the available supply. For when a constant, or rising, demand for any item meets with a reduced supply, the item's price naturally rises.

Like when the supply of Tickle Me Elmos ran short during the 1996 Christmas season, the originally-priced- $28.99 spasmodic muppet toy was going for thousands via the internet.

Of course we know why the likes of OPEC, or a toy company, controls the availability of its wares, but what inspires the Fed to control the availability of money? Well, it's that the Fed is held to a mandate that requires that it influence the price of oil and the price of plush children's toys.

Think about it: In the Tickle Me Elmo example, the price rose because the available pool of desiring money was far greater than the available pool of red ticklish muppet toys. Therefore, their price shot through the proverbial roof (they call that inflation). Now expand your thinking to the economy overall. If money is super cheap and easy to get, it'll get got, and it could potentially (after a fashion) get spent at a pace that could send overall inflation off to the races (I call it the More Money Wanting Elmos Than There are Elmos phenomenon). History is replete with characters in control of printing presses who got way out over their skis and caused avalanches of inflation. Again, today's Fed has a mandate that says don't you do that.

So then, if the Fed fears that money is cheap and available to the point where the price of a toy, or toothpaste, might accelerate to the extreme, it'll cut its available supply (resulting in what I call the Less Money Available to Buy Elmos, Which Keeps Elmos in Stock at a Reasonable Price phenomenon)---which, as borrowing banks then clamor for access to a smaller pool of money, pushes up the pool's price. 

The Fed closely monitors the process and gently tickles the supply of money to maintain the price (interest rate) range its after.

Back to why all the hullabaloo: Less available money means less money chasing stocks, higher interest rates on fixed income assets (competition for stocks), higher cost of borrowing for companies (lower profits) and the higher cost of home and auto loans for consumers (less economic activity, and lower profits), which makes for nervous equity markets. Hence my lack of sympathy with the consensus view that the market is going to take the beginning of the next Fed tightening cycle in perfect stride---despite the still historically low range we'd be looking at.

Now, I'm not predicting that the market is about to come crashing down in some epic fashion (although anything can happen). I happen to be in the camp that believes the economy is indeed healthy enough to withstand a slow and steady increase in borrowing costs going forward. And if my camp has it right, stocks---with their attendant volatility---are probably okay for the time being. Although the market leadership (in terms of sectors) is surely to change as the Fed slowly exits the lowest interest rate policy since the beginning of mankind. And, again, I'm guessing the transition to the next phase might be somewhat rocky in the beginning.

My challenge as an investment counselor is to find where the opportunities lie under a monetary regime different than the one we've experienced during the past 6 years+. And, thus, to---at the margin---exploit those opportunities in a manner that improves the performance of our clients' portfolios without taking undue risk.

So, should the Fed indeed take the barely-inclined exit ramp and begin tickling the market with slightly higher rates, and should the economy continue to chug along---with an arguably tight labor market ultimately pushing up on wages, and an arguably loose commodities market tightening up on production---we should begin thinking about what the sector, asset class, and geographic leadership is likely to look like going forward.

And that's what I've been up to lately. In the following I chart what I identify as the 8 Fed tightening cycles over the past 40+ years (where there were merely slight pauses in the pace of Fed rate hikes I combined what others might deem to be two separate cycles). My objective is to identify how different areas of the world and areas of the equity markets tend to respond to a tightening U.S. monetary policy.       

Click to enlarge...



As you gathered from the charts, and as you'll see in the following table, history suggests that a tweaking toward more exposure to non-US markets and commodities (and/or commodity-related stocks) would have delivered very nice dividends to the patient investor's diversified portfolio.

Note: The data back to the early '70s was only available for the U.S. market (S&P 500), developed non-U.S. markets (EAFE), commodities, transportation stocks and utilities. We, therefore, have to be careful drawing conclusions from the performance of, say, technology stocks. The data on the S&P Tech Index was only available for the past three rate hikes, two of which occurred during the expansion of the '90s technology bubble.       Click to enlarge...



So (you clients) there's your primer for our upcoming portfolio review meetings.

Have a Wonderful Weekend!

Marty