Fed Driven

Markets had a tepid open this morning as TV business programs and online articles gnawed and drooled over various projections about the direction of the Federal Reserve’s announcement this afternoon. Since Chairman Bernanke’s remarks about a tapering of the Fed’s $85 billion in monthly bond purchases, the various indexes have been buffeted to and fro on the winds of will-they-or-won’t-they.

We feel old fashioned as we remember when investors focused on balance sheets, earnings, innovation, and supply and demand. An article on CNBC.com assured readers of imminent tapering by suggesting the Fed is concerned it is creating unintended asset bubbles. Another article posited the opposite. This sort of petal-plucking analysis (she loves me… she loves me not) typically misses the point. The point is not what the Fed may or may not do; the point is that the market is balanced on Fed activity instead of fundamentals. This flies in the face of free-market philosophy and highlights the artificial pricing we presently enjoy.

Fundamentals and the free will of traders are the most effective discerners of financial asset pricing. While ‘proper prices’ may be higher or lower than they are in the current government-supported environment, we simply don’t know where stocks would be trading if monetary and fiscal policy hadn’t been so accommodating for so long. Moreover, we don’t know where prices will end up as government dollars are withdrawn.

Fiscal and monetary accommodations have had significant effects on the economy too. Interest rates have been held at century lows in an effort to facilitate economic healing. Whether you are a proponent or detractor, the economic data have improved. The data have improved modestly, but they have improved. The deficit has improved as well. It has come down in absolute terms and as a percentage of GDP. The projected deficit (per the Congressional Budget Office) for fiscal 2013 is $642 billion, or 4.0% of expected GDP. The actual for fiscal 2012 was $1.087 trillion, or 7.0% of GDP. These are good things, but what happens to the trajectory and momentum of the economy when accommodation is withdrawn? If interest rates increase by two just a couple of percentage points, the US Treasury will face an additional $350 billion per year in interest payments on the national debt. The effects will be compounded by the fact that the Treasury has not fully taken advantage of the low-rate environment to extend its debt maturities. Ultimately, the higher debt service will result in further tax burdens, which will put a cap on economic growth.

As the government’s role as economic hall monitor is debated and global markets and foreign economies adjust to their own challenges, our focus is on investing in the old fashioned companies with strong balance sheets, increasing earnings, strong cash flow, and seasoned management teams. Warren Buffet says, “When the tide goes out, you get to see who has been swimming naked.” When this economic tide shifts, we choose to be clothed in some of the world’s best companies.

Peace,

Michael