NEVER FIGHT THE FED
FIRST RULE OF SURVIVAL IN A RISKY WORLDPrepared by AIC Investment Advisors, Inc.
One of the first rules of investing that aspiring young investment managers learn is that one should never fight the Fed. If in the combined wisdom of the Federal Reserve governors, the belief that market speculation is becoming unruly, seasoned analysts realize that the Fed will act to calm the situation. It has now become apparent that Mr. Greenspan and the other governors have decided that markets are acting erratically. Investors may be well assured that Mr. Greenspan and associates will act to moderate the situation.
First Line Of Defense
The first line of defense is gradual increases in the Federal fund rates. Increases of 25 basis points in the Fed funds rate have been imposed since June of 1999. To date, these increases have not dampened speculative influences in equity and derivative markets. Despite the downturn in equity markets since the peace in March, Mr. Greenspan has been very specific in describing the impact of the wealth effect on the market for real goods and services. With the increases in prices now showing up at the consumer and wholesale levels, the word has gone out that the Fed may elect to increase the Fed funds rate by another 25 to 50 basis points at its June meeting. Rumors are spreading that the Fed wishes to see short-term rates at 7.0%. The words of the Chairman of the Federal Reserve are not to be taken lightly.
A Shift In Concern
In the recent past, the focus of Mr. Greenspan's concern has shifted from one of talking about irrational exuberance in equity markets to an outright concern over the harm that the wealth effect is causing within the real economy. Concerns of labor shortages and rising commodity prices now make up his carefully crafted rhetoric.
Without admitting that equity values may well represent purchasing media, Mr. Greenspan carefully explained how the rising values of stocks were creating additional purchasing power for which no additional good and services were being offered in the marketplace. The Chairman further noted, "The sharp rise in consumer outlays relative to disposable incomes in recent years, and the corresponding fall in the savings rate, has been consistent with this so-called wealth effect on household purchases."
The Second Line Of Defense
If rising interest rates fail to have the desired effect over time, the Fed may fall back on its second line of defense. This quite simply is to raise the margin requirements for investors. It is estimated that nearly 40.0% of the money invested in the Internet-related market is borrowed money. If equity prices continue to display speculative influences, investors should expect an increase in margin requirements, perhaps only a small increase (a shot across the bow, so to speak), that will send investors a definitive message regarding the seriousness of the Federal Reserve's concern.
Banking Evolution
In an address to bankers in Chicago on May 4th, Mr. Greenspan discussed the changes that have occurred in banking during the past 35 years. The two most noticeable changes in the financial markets in the Chairman's opinion were "the growing use of financial derivatives and the increasing presence of banks in private equity markets." The thrust of his comments was directed at the risk to the banking system, especially the large banking institutions which are significant factors in these areas, and of inherent risk to their capital accounts that could arise from operational errors in the unfamiliar derivatives markets. In later Congressional testimony, Mr. Greenspan warned that the Fed could not be expected to bail out the system as a whole if rampant speculation persisted and unwarranted risks were assumed in speculative banking ventures.
The Federal Reserve is faced with the challenge of controlling speculation, and in some instances, in outright gambling in the nation's financial markets. The difficulties that this entails under a system of fiat money, both domestically and internationally, will be interesting to monetary economists and students of the stock market. In the absence of a clear knowledge of what money is, as Mr. Greenspan admitted to Representative Ron Paul (R-TX) during testimony at a recent Congressional hearing, the problem presents a difficulty with which neither the Federal Reserve nor the banking system has a clear understanding.
While the learning exercise is underway, investors should be wary of the risks to their capital and assume a defensive investment posture in equity markets.
Consumer And Producer Prices...A Different Picture
There has been much talk among some analysts that there is no inflation (rising prices) developing in the economy. These observers contend that prices are not increasing sufficiently to justify a further increase in interest rates. The accompanying charts of the trends of the Consumer Price Index (CPI) and the Producer Price Index (PPI) show a different picture. These charts indicate that prices at the wholesale and retail levels are moving higher and that year-over-year increases are near the highest rates recorded during the past decade.
The Federal Reserve is likely to view the CPI and PPI trends as the natural result of the rapid increase in equity prices and the accompanying wealth effect that would, in due course, flow over into the real economy. From the price action of the recent few months, the wealth effect is beginning to impact the real economy. It is expected that the Federal Reserve will increase short-term interest rates at its May 16th meeting. The question for the past several weeks has been whether the increase will be 25 or 50 basis points. Now some commentators are looking for a 50 basis point increase at the May meeting and another 50 basis point in June. A Fed funds rate of 7.0% may not be far off.
Consumer Price Index
The March jump in the CPI of 0.7% was the highest in five years and followed a 0.5% increase in February. The recent rate of increase in the CPI, near 3.7% on an annual basis, is at the highest level since the early 1990's. The price increases now being experienced are broad based and extend throughout the economy; the increases are not confined to food and energy any longer. The Federal Reserve may be expected to act to implement a monetary policy that will reduce the wealth effect of speculative price movements in equity markets. Equity markets did not ignore the report as prices immediately headed lower on the announcement.
Producer Price Index
The rapid increase in wholesale prices has yet to filter through the economy, especially in the food and energy sectors, but will filter through the economy in the months to come. Increased oil prices are not likely to drop much below the $25 to $27 per barrel level in the foreseeable future. OPEC intends to maintain a stable price near that range and not a lower price, as some commentators expected. All things considered, the long period of reasonably stable prices may be coming to an end.
Questions And Answers...
Question: Is "buying the dips" the best investment strategy?
Answer: In a word--no. So many new investors have been lulled into believing that price corrections are always followed by a return to previous price levels or go on to a new high. This unswerving belief that every retrenchment in stock prices is a buying opportunity is hardly sound investment policy. Historians have correctly pointed out that more money was lost on "buying the dips" after the 1929 stock market crash than was lost in the crash itself. The reason was that investors who avoided the major crash came into the market again in 1930 with a "buy on the dip" philosophy. The market fooled them and continued to slide during the early 1930's till the bottom in June of 1932. Psychologically, these investors believed that their purchases in 1939 were executed at the bottom of the downturn. After prices continued to weaken these investors likely developed a costly sense of stubbornness about their decision to "buy the dips." They believed that their judgment was superior to those who were caught in the initial collapse. As more and more of their funds were committed to the falling market, many of these investors were eventually wiped out. The market drifted sideways to lower during most of the 1930's until the inflationary policies generated a recovery in 1937. The 1937 rally was followed by one of the sharpest drops on record. "Buying the dips" can be costly indeed.
In our judgment, it is dangerous to get caught-up in the latest speculative bubble. Market promoters (noisemakers such as those on CNBC) use hype to create excitement about the market. Using interviews with young, unseasoned "market professionals" with facile command of market terminology, these modern day Pied Pipers will lead many to their economic ruin. The B2B and new economy and other catch-words have come into the lexicon of the English language in a few short months or years. In the maze of Internet start-ups and other dreamscapes offered in the marketplace, the age of the Internet Bubble is now deflating. In a majority of instances, it was largely based on the willingness of investors to "buy a story." Companies with no revenues, no earnings--with only an optimistic business model, raised billions of dollars in prospects and hopes that never will be realized. The current market dip came about from excessive market levels, in our opinion, and the lower price levels today may not yet be the "bargains" of tomorrow. Investors would be wise to remain cautious at this writing.
Question: I want to participate in the technology sectors of the market because these sectors seem to offer the greatest growth in the years ahead. However, I'm afraid of the volatility. I've seen some stocks drop by 50% or more in a single day on only slightly negative news. How may I participate for the long-term with the least risk to my money?
Answer: The key word in answering your question is "long-term." By its nature, long-term eliminates much of the risk because short-term expectations are minimized. The key to success is now to purchase those issues that will occupy a dominant position in their particular technology sectors in the years to come. This is more easily said than done in high-tech industries subject to rapid changes because of new discoveries and the development of new technologies. There are many ways to break down the technology industry for analysis purposes. One of the most basic methods is to separate the basic companies (those providing the necessary elements for the Internet to operate, i.e., manufacturers of computers, communication devices, cable lines, etc.) from those offering services on the Internet, i.e., Amazon, Ebay, Priceline.com and the like. Even many of the basic companies are selling at price/earnings multiples that discount hoped for earnings at unrealistic rates. Some outstanding tech companies trade at extremely rich price/earnings ratios, and this brings in another level of risk, specifically, timing. Picking the best companies in a known industry is a challenge--and even more so in an industry that offers an ever-changing roadmap like the high-tech industry.
We believe that the safest way for the average investor to participate in the technological revolution and reduce the risks of loss to an acceptable level is through the purchase of mutual funds that invest a portion of their assets in companies engaged in the high-tech industries. Mutual funds offer investors immediate diversification among an array of the more outstanding companies. The timing risk issue can be tempered by making an initial deposit of 20% of the amount you wish to invest in the mutual fund and continue purchases on a dollar-averaging basis over a specified period of time. For example, invest the remaining 80% of money to be committed to the mutual fund evenly over the following 16 months.
May 15, 2000 Richard F. Maloney and Paul Maloney AIC Investment Advisors, Inc. 30 Stockbridge Road, Great Barrington, Massachusetts 413-528-9779