On Thursday, the Fed decided to hold rates steady at near zero. The decision could have gone either way, and the markets rallied into the decision. When the decision was announced at 2 p.m., the markets rallied again, over 150 points. Then, when the Fed text was read, the markets turned around, closed for the day, then fell another 290 points on Friday. The bond market rallied big time and the dollar fell. The Fed's message, rather than being optimistic about the future, painted a different scenario, explaining that foreign problems could create hurdles for growth here and will hold inflation well beneath target levels for a longer period. Instead of declaring victory as I discussed last week, the Fed painted a more pessimistic view of the future due to issues abroad. It's interesting to note that Bill Gross, the noted bond king, said after the decision that "it was a surprise that overseas economic issues rose to the top of the list for the Fed rather than staying near the bottom as in past years."
The Fed comments that inflation will stay well beneath expectations for the foreseeable future due to problems overseas led to deflation fears, which periodically exist in the Eurozone and Japan. The Fed needs to always exude confidence, as it is something sorely needed at both the corporate and individual levels. After hearing the Fed comments, would a board approve increasing capital spending or employment? Would an individual go out there and spend more money increasing debt? I doubt it. So, the Fed comments about slower growth became a self fulfilling prophecy. How dumb! Even dumber? Pundits like Jim Cramer hailed the decision!
I did not stand still after the decision. I added more puts on the DAX and JAX indices, expecting their currencies to increase, hurting their economies; I reduced my long dollar position, as I expected the dollar to fall as interest rates rallied, narrowing the interest rate differential; and I sold some of my trading positions, including APPL and DIS. I made 7 percent in each in just a few weeks. I also added to my energy shorts. I differentiated between trading and hedging positions and long-term investments. I try not to disturb my investments unless there is a change in specific outlooks or if they became fully valued. This goes for longs and shorts.
Let's look at the week's events, consider the Fed comments and decide if there should be a change in our longer-term investment outlook. Will any of our core beliefs change?
1. Clearly the United States took center stage last week. We discussed how the Fed held off on raising rates, blaming increased risks overseas, which could penalize near-term economic results. The Fed decision helps emerging markets at the expense of the euro and yen. Take notice of the changes the Fed made in its Fed funds rate targets for 2016-2018: It won't reach 3 percent until 2018 and will be only 1.5 percent by end of next year. The Fed lowered its economic growth and inflation forecasts for the next two years, too. Inflation won't even hit 2 percent by 2017. Guess low energy and commodity costs are not transitory, as the Fed said earlier. Lower highs and higher lows for economic growth for the foreseeable future remains one of our core beliefs. Also global competition, lower input costs and higher productivity will keep inflation contained, along with historically low interest rates. But we still do not like bonds, as we expect the yield curve to steepen after pausing here.
Economic data was a mixed bag: U.S wealth hit an all-time high last quarter, while individual debt levels are lower than where they were before the last recession; consumer expectations fell to 44.5 and only 25 percent of Americans see a better economy ahead; housing starts fell 3 percent while applications for building permits rose 3.3 percent; consumer prices rose only 0.2 percent year over year while core inflation actually rose 1.8 percent and retail sales rose 0.2 percent from a month earlier after a sharply higher revision for the prior month.
2. The economy in the Eurozone continued to improve as we went through the summer, boosted by a record trade surplus due to the weak euro. Here will be the rub: if the euro rallies over the next few months due to the Fed decision to keep higher rates on hold. We consider a rally in the euro just a counter trend move as we still anticipate a strong dollar over time—a core belief. Along with a record trade surplus, industrial output picked up meaningfully over the summer.
3. ECB Vice President Vitor Constancio commented that the ECB has plenty of room to increase QE if needed by drawing comparisons to the amount purchased by the Fed and Bank of Japan. "The total amount we purchased represents 5.3 percent of GDP of the euro area whereas the Fed … spent 25 percent of U.S GDP and BOJ spent 64 percent of the Japanese GDP. He added that the U.K spent 21 percent of its GDP. I hope that we do not move to competitive devaluation, which has been avoided for the most part so far.
4. Japan's economic activity has slowed appreciably over the summer, as its exports and factory output have suffered more than most due to the weakness in China, its largest trading partner. Exports to China fell 4.6 percent last month. Standard & Poor's lowered its credit rating for Japan one notch, as economic growth has remained weak while total debt has risen. Government debt stands at 200 percent of GNP, the highest of any developed country. The BOJ has not diminished its QE program and remains a large buyer of government debt. Reforms and higher wages are taking longer than expected to filter through the economy to stimulate domestic demand as exports weaken.
5. OPEC is talking a good game of higher prices, but the facts are that supply is still increasing more than demand, inventories are rising and prices are weak. I was amused that OPEC is forecasting oil prices rising to $80 per barrel by 2020. If I told you that a few years ago, you'd be up and cheering. Besides large potential for higher production in many parts of the world over the next few years, don't forget the rising opportunities for alternative fuels. Electric cars are getting more and more popular and the big boys are entering the field in force. I remain bearish on energy prices, which remains a core belief.
So what really happened last week and how does it influence our thinking?
I am most disturbed that the Fed did not imbue confidence last week about the economy. I have said many times that a conservative bias permeates all levels of government, corporations and individuals. That remains a core belief. If I heard the Fed loud and clear, I'd buckle down for a while until the outlook for foreign growth improved. Even though exports are less than 15 percent of our economy and less than 1 percent to China, globalization impacts all markets and right now there are heightened risks.
I have mentioned before that I invest in companies, not the market. If I am correct that my long investments are going through positive changes to increase volume, revenues, margins and free cash flow, these investment will be revalued upward over time and be very profitable. On the other hand, my shorts are just the opposite and incremental rates of return are declining. These stocks go down over time.
While my long and short investments make up the vast majority of my portfolio, I do maintain some trading positions used to hedge risk. I mentioned some of them earlier in this piece. And I maintain excess liquidity at all times, never being more than 95 percent net long.
I want to conclude that the Fed is just stating the obvious and is behind the curve. I am confident that the Chinese government is doing what is needed to stimulate the economy while sticking to its new reforms. Patience is needed, as the fix does not happen overnight. Even though the OECD cut its global forecast once again, it still is forecasting 3 percent growth this year and 3.6 percent in 2016. The U.S stands out by the way and there was a sharp upward revision for the Eurozone. So things are not so bad.
I am sorry the Fed painted a cautionary picture. They were late to the party and I hope they do not get behind the rate curve. My core beliefs remain for the most part intact. A steepening yield curve is delayed once again and will impact financial stocks. The preconditions for a market top are just not present.
