No Honeymoon for Janet Yellen
On Janet Yellen's first day on the job as Fed Chair, the Dow Jones Industrial Average dropped 326 points; 10-year Treasury yields fell to a mere 2.58%. While a day does not set a trend, let alone create a legacy, there is no honeymoon for Janet Yellen. Volatility, seemingly absent in 2013, is back, with major implications for investors' portfolios.
When I was a guest on CNBC on Monday to discuss the Yellen Fed, my fellow panelists brushed off the uptick in volatility, suggesting choppiness is merely a stepping-stone ahead of the next leg up in the stock market. I felt like screaming, but opted not to wake up this very civilized group, let alone the audience. Here's the problem: in our assessment, much of the recovery has been based on asset price inflation. The theory goes that the underlying economy can heal on the backdrop of soothing Fed policy. But when much of the recovery is dependent on high asset prices, the "progress" achieved can evaporate at any point, as asset prices can go down, as much as they have gone up.
My personal favorite bubble indicator is complacency. When asset prices move higher on the backdrop of low volatility, investors appear to pile into an asset or asset class without fully appreciating the risks. It happened in the nineties with tech stocks and last decade with housing. Or emerging market bonds: investors piled into these markets, ignoring how volatile they can be. The same holds true in US bonds: bond prices are historically volatile; but when the Fed smooth talks the market, investors might glaze over the risks. Then, when risk comes back, investors are caught off guard and run for the hills. But don't worry, pundits will tell you it's a buying opportunity. Of course at some point, if there's enough fear in the market, as volatility has raged for a considerable time, attractive buying opportunities might present themselves.
One of the reasons "everyone" appears obsessed with the Fed is because they control the printing press and, thus, have a significant impact on asset prices. But even before we add the uncertainties surrounding the leadership transition at the Fed, the Fed is setting itself up for trouble. And today I'm not even talking about tapering quantitative easing, the prelude to any "exit." No, I'm talking about Fed boxing itself into a corner with words. This January, the statement by the Federal Reserve Open Market Committee (FOMC) was 830 words long; ten years ago, the FOMC statement was a mere 200 words, a 315% increase. Proof that this word inflation is only asking for trouble is the well-known employment threshold. Recent FOMC statements state: "The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent" Well, the employment rate is now at 6.6%; the moment the Fed removes the reference, odds are the markets will price in a rate hike, even as Janet Yellen is in no mood to raise rates anytime soon.
And that's a problem for Janet Yellen, assuming her thinking is along the lines of former Fed Chair Bernanke. Bernanke was very explicit in stating that raising rates too soon during the Great Depression was one of the gravest policy mistakes at the time. But fear in the market - a rise in volatility - has a similar impact, making for a less favorable credit environment. The reason this is so important is because a recovery based on asset price inflation can falter. It is because of this that we believe the Fed has all but promised to be late in raising rates, i.e. is all but promising inflation.
The Fed may well be the primary source of volatility. Much of it is because the Fed is transparently confused. The Fed is confused because it cannot look at market-based indicators to gauge the health of the economy (because its own policies have distorted prices). As a result, they must read the tealeaves of imperfect and backward looking economic data not something that they have a particularly good track record of doing. Let's also not forget that with so much leverage in the economy, any small policy shifts may have an amplified impact on the markets.
So what does it all mean for investors? It means fasten your seatbelt. Independent of what the specifics of the economy or even the Fed are going to be, if your equity portion now has a bigger share in your portfolio than you historically have (which is likely given the rise in equity prices), consider taking chips off the table. The stock market peaked in October 2007 ahead of the financial crisis, before finding a bottom in March 2009. The time to take chips off the table is before, not after, prices plunge. Once investors have lost a great deal in the markets, it is wrong (and maybe impossible) to double down, even if it is the bottom of the market because odds are investors cannot afford to put too much at risk given the losses they have just faced.
Cautioning investors to take chips off the table is the easy part. Telling them where to put the money is more difficult because of two drivers, courtesy of our central bankers:
- There may be no place to hide. Cash is at risk as the purchasing power of the dollar erodes. If there is no place to hide, investors can still invest, but must get rid of the notion of a risk free asset.
- Asset prices appear to be mostly driven by what I call the "mania" of policy makers rather than fundamentals. However, if there is one good thing to be said about policy makers, it is that they may be predictable, providing for trading opportunities.
Bonds may not provide long-term refuge given the fiscal challenges ahead. Gold has lived up to its role as a diversifier in the past, but given that our daily expenses are not priced in gold, it can be a volatile ride that investors must be able to stomach. As our long-term readers know, we like investors to consider the diversification benefits that active currency management provides. An investor wins currency wars by tackling currency risk at its core, while mitigating interest rate and credit risk, and avoiding equity risk altogether. Bernanke used to talk about the Fed's toolbox. Similarly, investors may want to think about what's in their toolbox.
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