In an interview on CNBC last week Warren Buffett said that he believed stocks are fully valued. This corroborates with our own view particularly about US equities. We assume that Buffett must have held this view for some time as equities have more or less traded sideways since the beginning of summer. Furthermore, being a long term investor, we assume that he believes the Fed’s QE programme has been insufficient in mustering anything more than a short term rally.
As is now well known, the US Central Bank decided last week that that the time was not right to start tapering QE. Since then, we have not heard of many commentators who think that this was a wise decision, and in fact, most commentators appear to be very surprised. We were totally baffled by the decision to not begin tapering and by the extremely dovish tone struck by Bernanke in the subsequent press conference. It sounded to us like the Fed have discarded the thresholds and triggers that they so carefully crafted as part of their forward guidance policies.
Of course, the initial market reaction in the minutes immediately after the announcement was to push equities, gold and bonds higher and the Dollar lower. By the end of last week, some markets had reversed a good portion of the post Fed move and this week has started in lacklustre fashion. Back in late summer 2012, when the Fed moved to QEternity, a number of markets reversed the very next day and the S&P suffered a near 10% decline by mid-November. Can the same happen this year? A number of markets have put in place short term reversal signals so it is certainly possible. The first chart below shows the S&P 500 last year and the second chart shows the current set-up.
Back to the Central Bank decision itself. The Committee spent a good part of 2013 preparing the market for the beginning of the end of QE. They told us that they wanted to be as transparent in their communications as they could be through the use of forward guidance. They effectively promised to start tapering at some point towards the end of the year and have now appeared to have backtracked. They pointed out that rising bond yields, which rose in part because the Fed suggested to the market they would begin reducing QE, were in fact part of the reason they decided not to reduce QE. Fed communication policy has become a reason they cannot stop printing money. This is absurd.
We are sure that all rational commentators and investors believe that the Fed cannot print money forever, and so it is just a matter of time until this stops. The problem is that the committee continues to back itself into a corner by telling the market that rising rates will dissuade them from reducing QE. However, as soon as they mention tapering again, bond yields will rise.
The Fed is also altering their unemployment target. Having originally told the market that QE would be finished by the time the unemployment rates reached 7%, and interest rate rises would be considered when 6.5% was reached, they have now discarded the 7% threshold and told us that the 6.5% trigger is no longer important. They appear, quite rightly, to be worried that the unemployment rate is falling because fewer people are in the workforce rather than more people finding work. Whilst this may be the case, we simply do not see how printing more money will encourage someone back into the workforce, especially when welfare payments are quite generous.
Therefore, with the Fed having no direct control over the creation of private sector jobs nor the number of people in the workforce, no control over fiscal policy and so far no success in lifting their preferred measure of inflation above 2%, they now tell us that the shift to higher yields, itself a result of their communications strategy, is a new headwind that encourages them to keep printing. What happens when bond yields come down and the Fed tells us they are ready to talk about tapering again? Bond yields will rise resulting in the Fed saying the tightening in financial conditions will be too much of a headwind and so they must keep on printing. All the while, the equity market keeps bubbling higher even when many Fed Governors seem to be worried about QE leading to bubbles in financial markets.
Two well-known fund managers made some interesting comments after the non-taper decision last week. Marc Faber said, “This will end in total collapse, but from a higher diving board”. Stanley Druckenmiller (a George Soros acolyte) said that there has never before been such a "re-distribution of wealth from the poor to the rich". These two highly credible individuals clearly do not think the Fed is running a prudent policy. The FOMC is most filled by academics that believe that they can twist a few knobs here and pull a few levers there, and they will be able to skilfully determine the outcome of an economy with over 300 million people without incurring any real costs. This is ridiculous to say the least.
Our view has been and remains that the Fed is part of the problem. Growth remains sluggish because their current policies are simply not part of the longer term solution. There will come a point in time when QE will lead to higher bond yields and falling equity prices and what will the Fed do then – print even more money? Simply put, the Fed is beginning to lose credibility.
We have made the case in recent months that a buy and hold approach to broad equity markets will not be a successful strategy for the next 7 to 10 years. When you mix this in with a Fed that is beginning to lose credibility, then we believe it makes investing into equities generally, but US equities in particularly, a potentially risky proposition.