At the end of its June monetary policy meeting, the US Federal Reserve open market committee (FOMC) stated that the economic recovery was proceeding and the labour market was improving gradually. Fast forward to August and the FOMC admitted that the pace of recovery in output and employment had slowed in recent months and that household spending remained constrained by high unemployment and modest income growth.
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Consequently, the Federal Reserve decided to reinvest the proceeds of the sale of mortgage securities it was holding on its books, into US treasurys. In other words, it was not shrinking its balance sheet. Quantitative easing (let us call it QE-1) is not going to be scaled back. This is not the same as announcing a further expansion of its balance sheet (let us call it QE-2). That decision would follow in short order. But, for now, let us stick to this decision and the reaction of the so-called research community in the financial industry.
At least two brokerage reports I have seen since the FOMC meeting have hailed the decision as positive for equities. I am flabbergasted. Will they ever learn?
What explains the equity market rally of the last few weeks? It is that for investors, broader concerns do not matter and that only corporate earnings do, with all their massaging and liberties with accounting standards, etc. In the US, if the corporate sector is really doing well based on real economic activity, how does one explain the Fed’s downgrade of economic assessment for the second half (H2)? Why did the market ignore that in the last few weeks and why should lower rates or non-exit from QE-1 be positive, if the logic for that extension of QE-1 is a negative assessment of the economy, barely two months after the Fed issued an upbeat assessment in June?
In my personal view, both the sell-side and investors (or whoever is actually doing the investing these days in US stocks) are displaying, for the umpteenth time, myopia. It appears that retail investors are not persuaded of the logic of the recent stock market rally. They are busy withdrawing money from equity funds. We do not know if institutional investors have been dumb enough to throw money at stocks in the US, unmindful of the macro risks. It could simply be the proprietary trading desks or the Plunge Protection Team of the US treasury that is doing the buying.
Otherwise, it is hard to explain stock market rallies on low volumes or the inexplicable last half-hour, one-hour rallies on no news. The flash crash in May remains under-investigated. Many are shying away from asking hard questions of the current microstructure of the stock market in the US. One thing is clear. It is no longer a case of a large body of buyers and sellers, who are individually incapable of influencing prices, interacting in a process of price discovery. In other words, it is no longer a market, as is normally understood.
In fact, the inexplicable and unfounded stock market optimism has not only turned many investors away but is also robbing the intellectual underpinning of financial analysis. Liquidity and proprietary trading driven by an incestuously cheering analyst community does not require educated or intelligent people to be employed to decipher the fundamental value of stock prices. Fundamentals are irrelevant to the bizarre trading conditions that have taken hold in stock markets lately.
One broker is taking heart from the fact that the Fed had not yet downgraded the growth outlook for 2011. Since when did the Fed become an accurate forecaster? Didn’t they just notice that the Fed revised its view for 2010 H2 barely two months after striking a tone of optimism? Or do they think that we should or would not notice? Mind-boggling.
To write that the retention of QE-1 and the launch of QE-2 are unalloyed blessings for investors is to commit an act of intellectual dishonesty. The sad part of it is that many are at this game nearly a decade after the industry’s dark practices were revealed when the technology boom ended. It may be more honest to declare themselves as salesmen and then go about spreading their wares rather than masquerade as respectable research analysts and strategists.
Those who are continuing to strike a note of optimism on Western markets are either ignoring the lessons of 2007—when the world ignored the mounting macro risks for most of the year—or, are whistling in the dark or doing both.
Investors should look to lock in gains now and wait for correction to buy into emerging market assets when the Fed launches QE-2. It is only a matter of time. What that would do to the US dollar and US stocks is anyone’s guess. Certainly, the country does not seem to have any stomach for the hard decisions that Raghuram Rajan has been advocating in his recent comments.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org