Investing in uncertain times

It is my obligation as a fiduciary to consider at all times where I might be wrong in my investing decisions.  While I always need to consider each individual stock, sometimes it is also important to contemplate the possible moves of the stock market as a whole.

This latter task is challenging, as I believe forecasting the market is a fool’s errand.  I leave it to Wall Street firms to set price targets for the market.  To save you the suspense, these predictions in my experience typically forecast a level 7-10% higher than the the current price.

While I do not “call” where the market will (or should) go, I try to be cognizant of where the market could go, especially if there is the potential for large, sharp moves.  Accordingly, I try to be aware of what might drive market trends.  Right now, central bank intervention (quantitative easing measures, bond/asset purchases, rate cuts, etc) tops the list.

Dr Bernanke defended the Fed’s recent actions and discussed further central bank intervention at a speech in Jackson Hole, Wyoming on Friday, Aug 31.  He made the following statements:

  • “Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity.” (emphasis – mine)
  • “Large-scale asset purchases [LSAPs] can … signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors’ expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates.”
  • “How effective are balance sheet policies? After nearly four years of experience with large-scale asset purchases, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields. For example, studies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. . . . .These effects are economically meaningful.”

I read these statements to mean that the Fed wants higher asset prices and higher stock prices.  Indeed, in interviews, Dr Bernanke has pointed to higher stock prices as proof of success of his policies.

Perhaps more important than Dr Bernanke’s Jackson Hole speech, one sentence from the FOMC minutes of July 31/Aug 1 2012 stands out in my mind: “Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.”  (emphasis – mine).  To emphasize further, the status quo is not sufficient.  Slight improvement is not adequate.  The Fed wants to see ‘substantial improvement’ for it to hold off from further intervention.

Additional stimulus measures from the Fed are not a foregone conclusion, but they are a highly plausible possibility.

I don’t know what the Fed will do.  I have read thoughtful commentary from smart people who have come to opposite conclusions as to whether there will be another round of quantitative easing (though, from my reading, the majority of expectations seem to be for further stimulus).  Given both the uncertainty and the significance of Fed actions, it’s important for me to think about how central bank interventions will affect my investments.

In the past when there has been central bank easing, high-beta stocks have posted disproportionate gains.  This makes sense, especially in the context of the “Keynesian beauty contest,” where investors buy the most volatile stocks, thinking these will have the largest gains in a rising market.  It’s easy to see how this could be a self-fulfilling prophecy.

Outside of possible Fed actions, September should have multiple macro-related events that could move stock markets.  These include:

  • Sept 6 – The European Central Bank (ECB) is due to meet and could discuss plans to provide funds to Spain and to hold peripheral EU interest rates in check
  • Sept 12 — The German Constitutional Court will rule on the constitutionality of the ESM (the proposed mechanism by which the ECB will bail out overly indebted member EU countries)
  • Sept 12 – Holland’s national elections (the leading parties in the polls have voiced anger toward bailout out southern Europe).

These are certainly interesting times.

Stock markets could swing in either direction depending on the outcomes of any of these events.  I am not worried about a move lower in the market, as our low net exposure should protect us in this event.  To the contrary, given Dr Bernanke’s comments, I want to make sure that our portfolio is not adversely exposed to big upside market moves.

In light of all of these considerations, we have pared back our exposure to high-beta short investments.  If more quantitative easing comes, these shorts would likely move against us.  Now we have the capacity to add these shorts back into the portfolio if the prices do indeed climb.

As I mentioned, we are net short in our portfolio.  I have more conviction in our short ideas than our longs.  This is partly because of the degree of overvaluation of our shorts and partly because of the definiteness of the catalysts we expect.  I have read some market pundits advocate ‘moving to cash’ (limiting exposure to stock investments altogether).  That advice seems sensible, at least to some degree, given that I can’t predict how macro events will unfold and what the swings of the market will do on a day to day basis.  However, I have strong conviction as to where certain stocks will be over time (and why they will be there).  I have learned that I cannot predict when such moves will occur, and I invest (and remain invested) as opportunities arise.


sources:  FOMC minutes, July 31 – Aug 1, 2012, Bernanke speech – Jackson Hole 2012, Keynesian beauty contest

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