October 2012: QE3 and Beyond

In our preceding Quarterly Commentary (July 2012), we discussed the Federal Reserve’s policies of Quantitative Easing (“QE”): the Federal Reserve buys bonds with newly created money in an effort to drive long-term interest rates lower.  We summarized the intended and unintended consequences arising from these policies, and questioned the wisdom of broadening and extending these policies.  We concluded that: 

1. The Fed’s unconventional policies have created temporary distortions in financial markets,

2. Investment fundamentals will prevail over those distortions, and

3. The distortions created by the Fed pose a heightened investment risk that should be avoided.

Last month, the Federal Reserve announced the much anticipated third round of Quantitative Easing (called “QE3”; also dubbed “QE infinity” for its open-ended time frame).  Leading up to the announcement, financial markets rallied higher.  Since then the Fed’s magic has fallen flat and the stock market has retreated.     

Make no mistake; the Fed’s policies have, by design, induced investors to dump their cash and venture into riskier investments, pushing stock, bond and commodity prices higher.  The Fed hoped that newfound financial wealth would find its way into greater consumption that would stimulate the economy.  However, stocks have become so richly priced in a world of tepid economic growth (that is slowing) that owning stocks at these lofty prices has become as distasteful as holding zero interest cash.  Now what?

It seems that many investors are so addicted to the temporary surges provided by Quantitative Easing they have turned a blind eye to the fact that economic growth is slowing worldwide, including the world’s four largest economies: the U.S., China, Japan and Germany. 

Think about this…

If the Federal Reserve’s policies of Quantitative Easing really are able to avert a recession and enhance economic growth, then why hasn’t the Fed taken similar actions and avoided the other 19 recessions since the Federal Reserve was established in 1913? Because these policies do not work!

The short-lived sugar injections investors are receiving from “Candy Man” Ben Bernanke may give investors a temporary surge in financial wealth (a paper phenomenon of higher stock, bond and commodity prices), but those injections have done nothing to create real wealth, that is, an increase in the production of goods and services (that would also lead to more jobs).  Stocks are a claim on future profits, and future profits are a function of growing profits that come from rising production.  It’s not happening.  Ultimately, the surge in stock prices will be fleeting unless there is a corresponding increase in the production of goods and services.

Prudence or Speculation… Pick one!

Although the Fed is coercing investors to take on more risk as an alternative to near-zero interest rates, it’s still a choice, not a requirement.  Speculators might take the bait, but prudent investors will not.  Speculators need not look at investment fundamentals (or, for that matter, anything else that makes sense). In contrast, conservative investors, like us, must adhere to the discipline of carefully weighing investment and economic fundamentals when making investment decisions and portfolio allocations.  We can’t simultaneously be prudent and take on speculative risk.  It’s one or the other. We have chosen the more prudent path. 

Bob Rodriguez, a Managing Partner of First Pacific Advisors, LLC (the sponsor of FPA Crescent Fund), said it well,

“Unfortunately, a strategy of following the Fed’s urging to take on greater risk will likely end in heartbreak.  Should the stock market continue its upward march, both our clients and FPA’s portfolio managers will be tested.  This is a time for discipline.  Given that economic growth is languid at best and is likely slowing, the divergence between the stock market and economic reality cannot be sustained.  One or the other has to adjust.” 

Investment Strategy

This is an opportune time to review our investment strategy and why we have positioned our portfolios conservatively, choosing prudence over speculation. 

Our investment objective is two-fold: profits and protection of capital.  We believe that current conditions warrant prudent investors to lean toward protection of capital, even if it means leaving some profits on the table.  The best course now is to emphasize capital preservation instead of riding the speculative wave of the Fed’s monetary policies. Even with our conservative predisposition, we have still been able to capture double-digit profits in the past year.

Our portfolios are conservative and geared toward defense: de-emphasizing stocks while emphasizing above-average reserves of cash and short-term bonds. Current stock allocations are below our benchmark (Morningstar Moderate Allocation Category). Stock allocations at the end of September were 42%, compared to 56% for the benchmark.  The under-weight in stocks is mostly offset by a corresponding over-weight in cash (19% vs. 9%).

This is an instance where it pays to remind ourselves of the four time-tested cornerstones of successful long-term investing:

1. Balance

2. Diversification

3. Moderation, and

4. Patience.

Deviating from these cornerstones is ill-advised.  In our 30 plus years of investment experience we’ve observed that losing sight of any of these four guidelines invariably comes with a cost.

The past year reminds us of the tail-end of the internet/technology stock boom in the late 1990’s.  As tempting as it was, there was no rational justification, beyond pure greed, to jump into that fray.  We chose not to and missed out on a speculative surge, but ultimately prevailed by avoiding the beating that followed and destroyed portfolios of the more bold and venturesome.  Making a buck doesn’t mean much if doing so sets you up to lose two bucks.

There are times when going against the crowd can feel uncomfortable, yet is imperative to maximize your long-term success.  We believe this is one of those times. Our job is to patiently wait for more attractive, low-risk opportunities that will arise, as they always do, then seize them by redeploying our ample cash and bond reserves available in your portfolio.  Discipline and patience are rare commodities that we believe will be well-rewarded.  ***

Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2012