Last Friday, billionaire hedge fund investor David Tepper sparked a 2%+ rally when he suggested that stocks are attractive regardless of whether or not the economy shows signs of recovery. Continued gradual improvement in the economic indicators, his logic goes, would be positive for obvious reasons – hiring would pick up, incomes and demand would improve, and corporate profits would increase. On the other hand, stagnation or even deterioration in the economy would be greeted with swift and decisive action by the Fed in the form of a second round of quantitative easing (QE2). This latter scenario has been deemed the “Fed put”. It essentially means that downside risk is limited because the Fed will be there to make sure investors don’t lose too much money.
Recent history would certainly suggest that Tepper is right. The Fed’s support for the banking system last year triggered a sharp rally in securities of all kinds, and smart investors like Tepper were there to benefit. He made billions of dollars for his investors and himself by betting on bank stocks beginning in March 2009. Tepper was not so much betting on bank fundamentals, because they were obviously awful. Rather, he was confident that central bankers would do whatever was necessary to return the banking system to health. And he was correct that in the process, steel-willed investors would benefit greatly by the surge of government liquidity.
This time around, Tepper believes that the Fed’s statement last Tuesday has created the backdrop for just such another rally. Here’s the sentence that has instilled so much confidence in Tepper and other investors: “The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.” This is the sentence investors have been waiting for and, sure enough, Bernanke & Company delivered. The flashing yellow light has turned green for Tepper and others. Bad news is good news again.
For our part, we are not so confident that the only direction is up for stocks. The market’s reaction to the Tepper interview seems to us to be another in a long series of overreactions based solely on short-term catalysts, not long-term fundamentals. Investors have become obsessed with turning quick profits by getting in and out of positions at the right time. The fundamentals, on both the corporate and economic levels, have been thrown out the window in favor of prognostications about government action or inaction. This is “Don’t Fight the Fed” taken to its extreme. And we’re not participating. True, the government was successful in pulling us out of a deep stock market swoon, BUT, and this seems fairly important, the government was not able to stop the S&P 500 from falling 55% in the first place. To assume that the government can and will prevent all pain seems unrealistic. Therefore, we’re not all all sure that bad economic news, in the hopes of further intervention, should be viewed positively at this stage in the game.
Is it really a positive that the economic fundamentals have yet again deteriorated to a point at which more government support, including QE2 and tax cut extensions, is needed to stimulate growth? Is it a positive that housing prices appear to be headed downward again despite near-4% mortgage rates? Is it a positive that consumer confidence sank to 48.5 – the lowest level since February- in September? Is it a positive that unemployment is still very near double-digits?
In our view, investors not only own a put on the market, but they have also sold a call. In other words, there may be a ceiling on how high stocks can go in this environment. If the economic data indeed improves, interest rates are likely to rise sharply as investors flee the safety of Treasuries in favor of riskier assets like stocks. Because this “recovery” has been so highly dependent on ultra-low interest rates, any meaningful increase in rates is likely to act like the cops arriving at the party before it really starts getting fun. In the opposite scenario, what if QE2 doesn’t work? How can this possibly be construed as a positive if a second round doesn’t achieve the desired effect? And this says nothing about the moral hazard that the Fed may be creating by stepping in to support stock investors every time the going gets tough.
We remain cautious in this environment. High quality blue chip stops remain reasonably priced, but investors aren’t buying these stocks. We have not seen the type of rotation into high-quality, defensive companies that we usually see when the economic backdrop becomes clouded. Rather, investors simply wait for the Fed to signal action and then they jump in with both feet. This is not investing – it’s trading. We are confident that market will ultimately return to an “investor’s market.” Until then, we will stick with our knitting.