The Market Plays Along as the Fed Gets It Wrong

By Wayne Ferbert  SEP 14, 2012 10:50 AM

The Fed has told the market that the economy is as bad as we all thought -- but the market rallies?


Do you hear that humming sound from Washington? It's the US printing presses making money! The Fed launched QE3 yesterday with a material size behind it. The fact that they have started QE3 ahead of the election really surprised me. But the size of it does not. If you are going to show the political courage to make this move ahead of the November vote, then you better do it big to show that it must have really been necessary.
But was it necessary? Was it even the right tool for this Fed to use? I think the answers are no, and no.
The best analogy I can make? This is a doctor that can’t figure out how to cure his patient and he is running out of ideas. So, the doctor gives the patient a shot of adrenaline. The adrenaline helps to improve all of the patient’s vital signs, but the improvement is only temporary. The doctor is just hoping that he can buy himself enough time to figure out what is really wrong, or even buy enough time for the specialist to arrive and provide some real cure to the problem.
The Fed’s decision to double the size of its buying program in mortgage backed securities (MBSs) will certainly help to keep interest rates low – especially in the mortgage market. Lower mortgage rates are certainly better for the housing market than higher interest rates. But the housing market faces headwinds that can’t be overcome in a short time period, and this boost by the Fed has a short shelf life.
If the Fed believes that the housing market might improve and provide a boost to the economy in terms of new jobs, then they are putting too many eggs in the wrong basket. Historically, the housing market has been a leader that helps to pull us out of recessions. But historically, the housing market was never a bubble that got popped and acted as a major cause of the recession to begin with. That is our circumstance now.
The challenges facing the housing market are significant: record unemployment, shrinking wages, high commodity costs, too many homeowners under water, record number of foreclosures in process...  and the list goes on. This move by the Fed will not generate enough job growth in the housing industry to make a big dent on our nation’s unemployment.
I am sure the other part of the Fed strategy is to spur some risk capital back into the market that might create jobs. If they buy MBSs from investors, maybe some of those investors might seek to redeploy their assets into investments that generate jobs here in the US. I think this is just wishful thinking. After all, US corporations are not lacking for the cash on their balance sheet to invest in ‘shovel-ready’ projects. US corporations have record amounts of cash on their balance sheets. They are just choosing not to re-invest that cash right now because the risk/reward dynamic in the US makes them wary. The uncertainty in Washington is not helping either.
I can understand the Fed action since they only have so many tools at their disposal and they felt a need to take action to help on the job front. But the Fed should have kept this action in its back pocket in case things get worse. Let’s remember that US corporate earnings are at a record level. Companies are not having trouble making money. That is still a major measurement of the health of our economy. The problem with jobs is a huge concern – but it is better handled by policy from Washington legislators, not the Fed. After all, what does it say that US corporate earnings are at an all time high while unemployment persists?
OK, so you know I think the Fed was wrong. And we know the Fed thinks things are bad, so they took this action. But the market rally really continues to disturb me. The Fed has told the market that the economy is as bad as we all thought – but the market rallies?
I know why it rallies! The two big reasons: (1) The Fed is buying risk assets (mortgages), which means that all risk assets get a boost. After all, the sellers of the MBSs to the Fed will need to re-deploy their assets. They will likely be looking for something with a return higher than the artificially depressed mortgage returns. (2) The Federal government has announced that it will throw money at the problems if they get bad enough. In the short term, lots of companies that produce goods and services stand to benefit from the influx of funds from the government.
But the long-term investor needs to be worried. The market cannot justify these valuations if the economy is truly getting worse. The Fed actions to print money also are a worry for inflation. So, while the market will likely extend its rally here, the long-term outlook is more worrisome.
The market has rallied slowly for two to three weeks in to this announcement. In other words, it saw the Fed action coming. The Fed even signaled it. So, I think the majority of the rally is baked in. We are approaching the highest levels that I think the S&P can justify on this Fed move – a level around $1475. Remember that the price of the S&P 500 (^GSPC) is just one of those vital signs the doctor looks at. Eventually, the adrenaline wears off – and then you still need to treat the patient!
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.