Ron Muhlenkamp Q3 Memorandum
Since 2008, the Federal Reserve (Fed) has been a huge manipulator of the money supply and of interest rates. Beginning with TARP (Troubled Asset Relief Program) in 2008—and continuing through Quantitative Easing II (QE2), Operation Twist, and QE3, the Fed has added over $2 trillion to our money supply (nearly $20,000 per household) and purposely bought U.S. Treasuries and mortgaged-backed securities to keep prices of these securities up and keep interest rates artificially low. The Fed first did this to avoid a financial meltdown in 2008-09 and continued it on the theory that it would help jumpstart the economy after the 2008-09 recession.
We believe that TARP helped avoid a financial meltdown. But we find it hard to find evidence that the subsequent QEs have helped to jumpstart the economy. We do think the QEs help support the bond and stock markets. But we also notice that Mario Draghi, President of the Central European Bank since November 2011, has had at least as much success supporting the European bond market without yet spending a euro.
We were told (and always believed) that the Fed wanted its manipulation to be temporary. Beginning in May 2013, market interest rates on U.S. Treasuries began to move up. By August 2013, the interest rate on the 10-year Treasury had climbed from 1.6% to 2.9 percent. Initially, this upmove in interest rates drove stock prices and price-to-earnings ratios (P/Es) down, as one would expect; (see Chapter 4 of my book). But, by September 2013, stocks had recovered to their levels of May and had actually surpassed them. And the Fed began talking about a “tapering” in its purchases of Treasuries and mortgage-backed securities; (currently at $85 billion per month or about $800 per household per month). In our judgment, the upmove in interest rates (from 1.6% to 2.9%) had brought rates near to where they would be without the Fed’s arm on the scale—and the stock market had absorbed this increase very well. This presented the Fed with a great opportunity to “taper off” its manipulation.
On September 18, 2013, the Fed chose not to “taper.” For two hours, stock prices went up and some commentators celebrated; then, prices went down for five days as strategists (and I) tried to understand what the Fed’s (in)action meant for the markets going forward.
Having broached the topic of tapering in May, and having carefully shifted his tone in June, July, and August to calm investor fears of tapering, why did Ben Bernanke abandon those efforts in September by not executing the action he had so carefully prepared the markets for? My real fear is that the members of the Fed don’t want to taper, that they desire to continue to manipulate interest rates, or that they believe their continued manipulation as now essential to the operation of our economy.
If so, it will continue to complicate market evaluations of companies and their securities—with profitability and inflation giving one set of values (refer to my book)—and interest rates giving another. The Fed’s legal mandate is to keep inflation in check and to foster employment. Despite this, one of its current goals is to increase inflation. Further, it is hard to find evidence that the Fed has increased employment. (Labor participation is the lowest it’s been since the 1970s.) But the Fed seems to have adopted increasing stock prices as a substitute for its mandate and is pointing to higher stock prices to justify keeping its whole arm (not just its thumb) on the scale of interest rates.
We’ve seen what happens when prices get ahead of the economy reality. The bubbles in the dot-com’s in 2000 and the housing market in 2007 were such effects. We fear that the apparent Fed desire to continue to manipulate interest rates may engender more bubbles.
The comments made by Ron Muhlenkamp in this commentary are opinions and are not intended to be investment advice or a forecast of future events.