July 2012: Update - Quantitative Easing

 

We are frequently asked by clients to explain the machinations of the U.S. central bank (the Federal Reserve, also referred to as “the Fed”) and how their programs impact investors.  In the past three years, the Fed has provided massive amounts of monetary easing by creating money and using it to purchase bonds.  This has decreased the amount of bonds and increased the amount of money in the financial system.  Their intent was to drive interest rates lower to encourage borrowing and spending, hoping this would promote higher economic growth. These programs are commonly referred to as “Quantitative Easing.” 

From 2009 through last year, the Fed purchased $2.3 trillion of bonds, primarily mortgage-backed securities (that is, pools of home mortgages packaged up and sold as bonds) and U.S. Treasury bonds.  The Fed simply created money electronically and used the money to purchase bonds – replacing $2.3 trillion of bonds with $2.3 trillion in cash.  This is the modern day equivalent of printing money.

The Quantitative Easing programs took bonds out of circulation and replaced them with cash.  This created a dilemma for the former bondholders finding themselves saddled with cash, earning virtually no interest.  With no earnings from their cash, investors sought to unload their cash, seeking other investments (stocks and bonds), hoping to improve their returns. 

Hot Potato Anyone?

But, wait!  Let’s think that through.  If John uses his cash to buy Mary’s stock, the cash doesn’t disappear.  They’ve simply switched positions; Mary now has the cash and John has the stock.  Next, Mary tries to do something more productive with the cash that earns no interest… and the hot-potato game continues.  Prices of stocks and bonds have been pushed higher and higher until reaching equilibrium with cash; the unattractiveness of buying richly priced stocks and bonds now matches the unattractiveness of holding zero-interest cash.

Liquidity Trap

We are now mired in a “liquidity trap.”  Regardless of interest rates being at record low levels, and regardless of how much money is available for lending, neither businesses nor consumers want to borrow and increase their indebtedness.

 

Consequences:  Intended & Unintended

The Fed’s experimental programs have not achieved the desired outcomes.  The Fed assumed (hoped?) that lower interest rates would induce businesses and consumers to borrow more, spurring the economy to a higher level of growth.  Their objective of lowering interest rates was successful, although at a cost of punishing savers, especially retirees dependent on interest income.  The Fed’s ultimate goal of encouraging consumers and businesses to take advantage of low interest rates to borrow and spend, and thereby propel robust economic growth, has not been realized. On the positive side, low interest rates have successfully propped up the stock and bond markets by inducing investors to seek investments (i.e., stocks and bonds) with higher potential returns than zero-interest cash.  However, short-term boosts to the stock market have proven to have little durability, much like a sugar fix that works temporarily, but dissipates soon thereafter.

Try It Again?

Notwithstanding a lack of success after two rounds of Quantitative Easing, totaling $2.3 trillion, the Fed is considering another round of easing to lower interest rates even more, as if that will finally, somehow, ignite the economy.  Today, not even an optimist can believe that a program of that magnitude that has repeatedly failed will miraculously work the next time around.

Last month, the Fed extended their latest program of easing called “Operation Twist.”  Operation Twist started in September 2011.  Rather than printing more money to purchase bonds, the Fed sold $400 billion of short-term treasury securities (with maturities as long as three years) using the proceeds to buy longer term treasury securities (6 to 30 year maturities).  The objective was, again, lowering interest rates to boost economic growth.  Before the program’s June 2012 expiration, the Fed announced a $267 billion extension of the program.  Only government could embark upon multi-trillion dollar programs that haven’t worked, then follow them up with more of the same and expect a different outcome.  Whatever happened to common sense?

Investment Fundamentals Matter

The policies of governments and central banks are now driving financial markets, dwarfing the importance of investment and economic fundamentals.  In our three decades of investment management, we have never seen this extreme.  Markets are easily, quickly, and dramatically swayed by the latest rumor or speculation about the next phase of Europe’s woes, possible policy responses, the next round of monetary easing by the U.S. Federal Reserve, or the latest tidbit of economic data.  Day by day, a single piece of data, a forecast, or a comment from a government official can send the stock market soaring (a “risk-on” day) or plummeting (a “risk-off” day). 

Rather than react to daily data, we choose to remain focused on investment fundamentals and invest portfolios accordingly. Economic trends that really matter to investment markets do not change direction on a daily basis; they unfold over periods of months and years.  Reacting to the latest bit of minutiae is, simply put, nonsense.

The benefits of prudently selecting investments based on their value, income, quality and safety may have temporarily taken a backseat. The operative word here is “temporary.”  Despite occasional lapses, and the distortions they cause, investment fundamentals eventually and always prevail (think about the technology stock bubble and, more recently, the housing bubble).  Ignoring investment fundamentals is dangerous and usually referred to as “speculation” and/or “foolishness.”

The cornerstones of our investment strategy are: balance, diversification, moderation and patience. This framework is time-tested and has served us well for many years and all economic seasons.  We are neither chasing the latest fad nor making investment decisions based on second-guessing the next Federal Reserve program.  We rely instead on our experience, knowledge, and judgment to make carefully measured investment decisions, seeking to protect our investors and capture profits.  We select mutual fund managers that see the world like we do, managers who judiciously avoid risks not worth taking and keep their eyes on fundamental investment values.

Conclusion

Stocks are richly priced. At this juncture, we believe the best course is to emphasize capital preservation, as we have done.  Our portfolios are positioned conservatively and geared toward defense: de-emphasizing stocks while emphasizing above-average reserves of cash and short-term bonds.   When improved low-risk opportunities arise, and they will, we stand ready to reposition portfolios as warranted and aggressively pursue the maximization of your long-term profits.

We take our responsibilities to you in earnest, and are grateful for the trust and faith you have placed in us by allowing us to manage your investment capital.  Thank you. ***

Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2012