Another day, another Republican debate. The DC strategy couple of Matalin and Carville spoke at a small gathering we attended recently. Matalin said that few understand how difficult it is to unseat an incumbent. Carville said three things: Romney will be the candidate; Romney cannot beat Obama; but Obama can beat Obama. From their comments, it sounds like they feel this election will be the President’s to lose. With more than eight months to go before the Presidential election, color us sick-to-death of all of it.

Big policy decisions in Washington have come to a standstill. Real votes and deadlines have been comfortably pushed beyond November. Though headlines breathlessly report of budget proposals and tax plans, be assured that nothing will happen beyond the political posturing.

While citizens wait and watch this embarrassing, deforming process unfold, investors continue to wrestle with the significance of Greece, and Europe, and what may eventually happen post-November when the Capitol Hill cabal are faced with taking real action. From any perspective, the electorate expects a diminished flow of government dollars. Moreover, they expect that deficit spending will be staunched and a path to fiscal responsibility will be restored.

Keynesian spending has exceeded rational sustainability. Even Keynes called for the reasonably timely repayment of debt incurred during economic downturns. Our current debt will take a lifetime to bring under control, and more time to repay.

The good news is that stock prices have been doing well, corporate earnings are increasing, and economic data are improving. It is a fragile recovery but a recovery nonetheless. But here’s the rub. What if, as happened in the 1930’s, fiscal and monetary policies are tightened before our toddler economy can bear the load? This is Chairman Bernanke’s great fear.

We were shocked in January when the Fed extended the projected period of near-zero interest rates from mid-2013 to late-2014. In addition, Mr. Bernanke vowed to provide additional support should conditions warrant. It was this language that sounded a lot like a promise of a third round of quantitative easing or QE3.

So what gives? If the economic data are improving and unemployment is indeed falling, why are we hearing all of this dovish, accommodative talk from the Federal Reserve?

Our best guess is that the Fed is trying to protect the economy from the executive and legislative branches and all of the policy uncertainty they create. We think the Fed sees QE3 as means to inoculate the recovery against potential shocks from fiscal austerity and policy uncertainty. As rhetoric of potential spending cuts and tax increases becomes more strident, I expect talk of QE3 to get louder. In many ways, the Fed is insulating investors from politically expedient Congressional actions that have the potential to derail the nascent and fragile recovery.

All are in tough spots. The President and Congress will have to take responsible fiscal steps that will upset some voters. The Federal Reserve will have to continue its delicate dance on the head of a political pin while fighting to maintain its independence. And Americans will have to endure the shenanigans and do what Americans do best: work, aspire, dream, and achieve. We are the one country that has done it over and over and against great odds. The odds are considerable at present, but woe to him who bets against US!

Hang in there,

Peace,

Michael

The Dow experienced a triple-digit sell-off yesterday, which has been somewhat of a rare occurrence over the past few months. In my estimation, the sell-off was triggered not only by the delay in the Greek deal (which certainly was a factor), but also commentary coming out of the Fed. The Fed released the minutes of its latest meeting, which suggested to me (and others) that another round of asset purchases (QE3) is not an imminent possibility. In addition, Dallas Fed President Richard Fisher blatantly told reporters yesterday that “there will be no QE3.” And finally, Philadelphia Fed President Charlie Plosser was on the tape Tuesday with his standard, albeit more aggressive, hawkish comments. These developments came as somewhat a surprise following Bernanke’s ever-so-subtle foreshadowing of a QE3 following the most recent Fed meeting. Bernanke has since repeated that the Fed stands ready to do more if necessary. Unfortunately, the markets have become conditioned to read into a statement like this. The interpretation is that there WILL be more action by the Fed. At the same time, markets have essentially priced in an extension of the payroll tax cut and an eventual extension of at least a portion of the Bush tax cuts. Therefore, we cannot help but conclude that the markets continue to be driven by the promise of easy monetary and fiscal policy rather than sound underlying fundamentals.

I was in Newark, Delaware on Monday and Tuesday, and I had the opportunity to sit down with Philadelphia Fed President Charlie Plosser. Plosser is a well-known hawk within the Fed system, meaning that he believes the central bank should be more vigilant in ensuring that inflation does not become a big problem in the future. He said that the Fed’s independence from politics is essential because the central bank needs to make decisions that ensure the LONG-TERM health of the economy. The first implication, of course, is that politicians are only concerned with near-term economic conditions as they must run for re-election every so often. In other words, no politician wants to make a decision that might result in near-term pain among his constituents because that would result in the loss of votes. Nothing novel about this idea. The second implication, however, is that the Fed’s monetary easing has indeed increased the risk of widespread inflation in the future. This inflation could show up in the form of higher commodity prices, higher prices for finished goods and services, and/or asset bubbles (read: stocks and housing).

Plosser believes that the economy and financial system are no longer in a state of crisis, and therefore monetary policy should not continue at crisis levels. In particular, adding a “commitment” to keep the Fed Funds rate at 0% through 2014 is a senseless pledge as future monetary policy will be determined by economic conditions and not by the calendar. We voiced this exact sentiment in our January 25 Market Commentary (and we repeated it the following week). Therefore, what was perceived by the markets as incremental easing was in fact simply a worthless pledge.

It should be noted that Plosser is not a voting member on the FOMC at this time. In fact, Richmond Fed President Jeffrey Lacker may be the only staunch hawk on the Board at this time. What does this mean? It likely means that investors will eventually get what they want yet again. Sometime down the road, while it may not be at the next couple of meetings, the Fed will likely implement QE3. But it has to end somewhere.

So what are we to make of the divergent opinions within the Fed? It our view, there are two possibilities. Either 1) Chairman Bernanke has a legitimate disagreement with Fisher, Lacker and Plosser; or 2) Bernanke does not expect to ever do a QE3, but he wants investors to believe in that possibility (or indeed likelihood) so they become emboldened and bid up the prices of risky assets. If the latter is the case, I would speculate that Bernanke is trying to buy time for Congress to provide more clarity on issues such as tax policy and regulation. Our fear is that if the latter is true, we could all be in a lot of trouble!

I’ve never been a fan of parsing each and every utterance from Fed governors. However, this is what it has come to. Investors cannot simply evaluate a company’s fundamentals anymore - they must also be able to forecast monetary and fiscal policy. And despite living in the DC area, I have no special insight into Bernanke’s thinking. What I would say, however, is that we must get off this treadmill some day. We fear that jumping off at full speed could lead to injury.

Peace,

Michael

Employment data were really good last week, and while it is just a single report, it was a very good report. Headlines this week are breathlessly devoted to all things Greek and European. In spite of rising share prices, there is no good outcome for Greece or the Euro short of survival. Though mere survival is preferable to vast numbers of alternatives, we find it a tough formula for ebullience.

Back home in the US, Consumer Credit surged in December, which means that the savings rate declined and debt increased. Many consumers have once again returned to deficit spending after a brief interlude of responsibility. The US economic recovery is continuing its slow recovery fueled in part by a renewed willingness to take on debt. For my part, I continue to believe that the consumer is not doing enough to get his financial house in order and save more for retirement. Savings rates are still more likely to drift higher over the near- to intermediate term, which could be a drag on economic growth for some time.

No matter one’s perspective, we are unable to consider current market conditions vibrant or robust. The economy is blessedly far from its earlier state of extremis but nowhere near ready to run the New York Marathon. While we are grateful to see the patient upgraded from the Intensive Care Unit to a standard nursing floor, it seems that even the most biased, loving relative would struggle to suggest our economy is fit for calisthenics or active duty.

The good news is that as a result of this tentative fragility, share prices for many companies are quite reasonable. When news is bad, share prices are low, and that presents opportunities to buy. There is money to be made by the disciplined investor.

Politics were the theme yesterday at lunch with Potomac Research Group’s Greg Valliere and cocktails with Mary Matalin and James Carville. Greg Valliere is one of the very few strategists I read daily. His daily report is brief, to the point, and enlightening. You can find out more about PRG’s offerings at www.potomacresearch.com. Greg has been forecasting Romney as the Republican candidate for some time. He has also correctly predicted Newt’s passing allure and Santorum’s rally.

Matalin and Carville agreed on many of the facts of the Republican campaign and of President Obama’s chances for reelection. They point out that Republicans always go with the front runner. Carville says that Romney will be the candidate but that Romney can’t beat Obama. He suggests that only Obama can beat Obama and that that is a real possibility.

Greg Valliere and I agree that among the greatest threats to the economy and investors in the years ahead is losing the Federal Reserve’s independence. Greg quipped, “we’ve seen how well Congress has handled fiscal policy; how well do we really think they’ll do with monetary policy?”

Enthusiasm is building as the market has increased almost 20% since September 30, 2011. It is uncanny how investors’ appetite for risk increases as risk increases. Technical chart patterns remain strong, but my hint of lumbago makes me think we are due for a pause. Investment opportunities are available for those willing to put in the work. Do your homework and watch where you step. This is not a riskless period. Period!

Peace,
Michael