Why The Fed Is In Trouble

Thinking is the hardest work there is, which is probably the reason why so few engage in it.

-- Henry Ford

I highly recommend you take the time to read. His message in that writing is wildly important for traders, investors, and asset allocators, and should put to rest much of the myopic thinking which unfortunately is pervasive in the business of investment management.

Last week was both typical and atypical. It is a well-documented fact that historically, stocks tend to gain the day before, during, and after Federal Reserve policy announcements. Indeed equities followed their historical script, rallying strongly at the same time the VIX Index was smashed. As we all know, there was nothing new -- the Fed remains in zero interest rate policy mode, and hopes to raise rates this year. Personally, I long for the day when the media will stop obsessing over when the Fed will raise rates, and rather turn its attention to the fact that the Fed has been repeatedly wrong in their outlooks for the future and the way they lull investors into enormous complacency.

There is a major problem for the Fed in the near-term and the Fed faithful -- wage inflation pressure appears to be lessening given last Friday’s data. This, combined with one of the worst months for commodities in some time, is pushing inflation expectations lower, causing widening of credit spreads in the marketplace. Long duration Treasuries are rallying to the same extent as the S&P 500, as market breadth continue to look very weak and emerging market stocks are in free-fall. These are not the kinds of conditions, should they persist, that the Federal Reserve raises rates into. These are the kinds of conditions that result in market volatility, corrections, and central bank scrambling afterwards.

Our indicators, which are proven leading indicators of volatility continue to suggest that a difficult period is ahead for cyclical sectors, implying that from an asset-allocation perspective, Treasuries and dividend sectors could strongly outperform. Indeed in the small sample of the last two to three years when equities had no downside with the benefit of hindsight, these indicators resulted in false positives. In other words, every time warning signs showed, equities ignored them. This time around, though, there are a number of warning signs appearing at once independent of our intermarket signals used in our mutual funds and separate accounts. This time around, there is no QE in the US as the excuse to ignore the red lights flashing ahead of us.

We suspect an environment more like 2011 and 2012is at our door step. That does not suggest the bull market is over, but rather that the behavior will change. Those were strong times for our approach to managing downside ris. Those were stressful times for the Federal Reserve. Either way, the Fed is going to have a tough time if financial conditions continue to deteriorate at the rate they have been. Headline averages may not be paying attention to that now. Often times, by the time one realizes they need to slow down while driving into the storm, it is too late to hit the brakes.

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Magnitude of loss potential versus frequency of gains history -- the battle has begun.

Written By: Michael A. Gayed