How Much Was Predictable? Count Your Blessings

This week’s market action has left a lot to be desired. But given everything that is going on, we should probably be thankful. After falling some 4-5% from its recent highs, the S&P 500 remains in positive territory for the year. Volatility has picked up a bit, but the sell-offs have been met with a steady flow of buyers to support the market. To say that the market has been resilient in the face of enormous shocks would be an understatement. And following gains of nearly 100% since the March, 2009 lows, investors should probably be saying a prayer of thanks to the investing gods. To demonstrate my point, let’s do a little exercise.

Imagine that today is December 31, 2010, and you are Joe or Jane Investor. You are going through your investments and deciding how to position your portfolio for the year ahead. You are feeling pretty confident following two strong years for the stock market, but you know that the economic recovery has not been as robust as it probably should be at this stage. You are especially concerned about the weakness in the labor and housing markets. However, recent Fed actions suggest the central bank will do anything necessary to support job creation and the housing recovery. You worry about the longer-term implications of the Fed’s actions, but you know that a sudden increase in inflation is unlikely due to the slack in labor and manufacturing. You also worry about the longer term implications of the huge federal budget deficits. You believe that the massive spending and huge federal debt will inevitably lead to higher interest rates at some point, and so you believe stocks are a better bet than bonds. And finally, you know there are exogenous risks to keep your eye on, such as the sovereign debt crisis in Europe.

On balance, you decide that the opportunities outweigh the risks, and you decide to maintain your equity positions for 2011. Now imagine that I gave you a crystal ball that enabled you to see into the future. You glare into your new crystal ball and you see the following:

  • Massive and widespread protests and rioting in the Middle East, including several key oil-producing nations. The rulers of Egypt and Tunisia are forced to step down, and Libya has descended into a veritable civil war. Protests appear to be spreading to Bahrain and Saudi Arabia. The price of oil spikes above $100 per barrel, leading many to believe that gas prices will spike to $4 per gallon or more in the US.
  • A record 9.0 magnitude earthquake hits the off the Northeast coast of Japan, causing a tsunami that kills upwards of 10,000 people. Several nuclear power plants are in danger of melting down, and residents in the surrounding areas are told to stay indoors. Radiation levels in Tokyo are slightly elevated. Economic losses are projected at anywhere from $100-$200 billion. The Nikkei plummets nearly 17% in two days.
  • Yields on bonds of troubled European countries are hovering near record highs (since the advent of the Euro) as investors continue to seek clarity on the timing and magnitude of bailouts.

Given your magical clairvoyance, how would you expect markets to react, and where would you think the Dow and S&P would be trading? Remember the golden rule if investing: “Don’t Fight the Fed”. More than ever, it seems, investors are willing to put their heads in the sands and ignore the noise as long as the Fed maintains its commitment to pump liquidity into the economy through low interest rates and asset purchases. Investors are increasingly willing to invest in stocks because they believe the Fed will be there to bail them out should the market take a turn for the worst. Economists refer to this behavior as “moral hazard”, and it is troublesome because it can create asset bubbles. Just as the Fed has kept mortgage rates artificially low, it may be goosing stock prices to artificially high levels.

One need not go too far back into the past to remember our most recent asset bubble – in housing. Then, as now, investors in real estate thought there was no downside risk in buying a house. Economists as renowned as Ben Bernanke himself dismissed the possibility of a nationwide decline in housing prices, while then-Chairman Greenspan kept interest rates very low for three years and encouraged the use of adjustable-rate loans to finance the purchase of a home. The result was an unprecedented increase in housing prices to unsustainable levels. Whether purposeful or not, higher housing prices cushioned the blow of falling stock prices at the turn of the century. However, as we have seen, Greenspan’s policies created an even larger problem. Is Bernanke doing the same thing over again?

At some point the risks of the Fed’s monetary policy will outweigh its benefits. The Fed cannot simply take stock prices ever higher and expect to ignite a sustainable, demand-driven recovery. Higher stock prices won’t, in isolation, lead to strong job growth. Higher stock prices won’t remedy our housing problems. And higher stock prices can’t offset the unforeseen global shocks that we have experienced thus far in 2011.

This recent decline has been very orderly. There have been no signs of panic and no “flash-crash” computer-driven surges. The conclusion is that in spite of lots of scary things going on in the world and in world economies, investor psychology remains optimistic, sanguine and perhaps even complacent. We remain defensive through investment in high-quality multinationals blue chips with strong balance sheets.