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How to Avoid Investing Idiocy by Ignoring the Fed

Far away from the frontiers of the 21st century, the US Federal Reserve is still stuck in the past…past errors of monetary policy…and textbook theories of macroeconomic management that neither promote recovery nor allow for past mistakes to be acknowledged. But yesterday the Fed was busy freaking out investors.

The Fed has no plans for another round of quantitative easing, according to the March 13th minutes of the Federal Open Market Committee (FOMC), which were released today. According to the minutes, “A couple of members indicated that the initiation of additional stimulus could become necessary if the economy lost momentum or if inflation seemed likely to remain below.”

The statement suggests the Fed thinks the US economy is expanding and that inflation is low. Thus, there’s no need for more “stimulation” with another round of Quantitative Easing. Of course, the Fed is probably wrong on both counts. The US economy is not on a long-term path to recovery and inflation is almost certainly higher than the official figures show.

It wouldn’t be the first time a central bank was wrong in its interpretation of economic events. But that is neither here nor there. The investment reaction to the minutes was swift and bearish. Stocks, gold, oil, and bonds initially fell. Stocks rallied a bit by the close, but still finished down.

All of this is nonsense.

That is, it’s absolute idiocy to base your investing strategy on expectations for more stimulus from the Federal Reserve. That is not the best reason to buy stocks. It is not even a reason. It is a hope, or probably just a gamble. At the worst, it is a giant, unproductive distraction from thinking about the things that will really determine whether you make or lose money in the next 10 years.

The Fed has succeeded in putting itself at the centre of day-to-day investment calculations. But this hasn’t promoted certainty about what to expect. It’s promoted speculation about how to get ahead of the Fed and profit from its next move. This attitude of front-running monetary policy has taken over asset markets.

We should backtrack for just a moment. Monetary policy certainly WILL have something to do with your winners or losers for the next 10 years. If your investment strategy is based on a benign belief that official interest rates will remain low and asset prices will benefit, you’re almost sure to lose money. You’ll get blindsided by just the sort of event that central bankers and economists are never clever enough to see coming.

But in saying this, we’re taking the other side of the trade from Goldman Sachs‘ chief economist, Jan Hatzius. He went on CNBC yesterday afternoon and said that more asset purchases from the Fed will probably happen by June. Hatzius says that Operation Twist – where the Fed kept interest rates on 30-year bonds low – is set to end in June. He reckons QE3 will be its successor.

Should you really take the other side of the trade with Goldman?

Well, in our view the best thing you can do is not to make the trade at all. Don’t base your investment strategy on expectations of stimulus and central bank asset purchases. That is a loser’s game. You can’t win it. The only way you can win it is if you’re a bank or a broker using leverage and gambling with other people’s money. Those guys can win because they can’t lose. The clients take the loss, the firm takes the profit.

Our mate Kris Sayce has taken the same view with his small-cap strategy for 2012. Kris did a good job of getting into the market in 2009 before the first round of QE. This liquidity boost lifted stocks all over the planet, including Australia. But each new round of QE or stimulus since has had a shorter and less significant impact on stock prices.

Kris has taken the view that the QE/stimulus discussion is an attention trap. Instead, he’s trying to find good small businesses with business models that don’t depend on leverage to increase earnings. More importantly, he’s looking for a small business that can increase its earnings dramatically, even in the current environment.

Of course he’s looking for that, you might imagine. We all are! Well, no, we all aren’t! That’s one point Kris has made in his newest report. If you focus on the small end of town and look at businesses from the ground up, you’re doing work that most people aren’t doing right now. That gives you an advantage as an investor. And that’s a great start.

The important point, we think, is that when you measure the market by a broad index like the All Ordinaries, you can see it’s done almost nothing for the last seven years. Granted, whether you made money or not determines when you began investing, and if you have any particular stocks that would have outperformed the index. But there’s an important point takeaway from all this.

$AORD

The takeaway is that the fund managers and index trackers hang on every word from the Fed because those words influence the indexes. All the Fed and central bank liquidity goes into the same big stocks and securities. For fund managers whose job it is to track an index, following the Fed is the key to avoiding professional embarrassment and meeting minimum performance standards.

They are playing an entirely different game from you, an individual investor. We’d encourage you to not play their game. If you play their game, you’ll see your index tracking funds and investments move up and down with various policy announcements. And then seven years later you’ll be no closer to meeting your retirement goals.

Seven years is a long time to make no money in the markets. Can you afford another seven years of flat stock prices? Another 12 years? Another 23 years? Those are not random numbers. If you’d bought Japanese stocks at the peak of one of their periodic rallies over the last 23 years, you would still be underwater.

Buy and fail for the long term

Buy and fail for the long term

Japan’s stock market peaked in 1989 and has never recovered. There have been multi-year tradeable rallies where you could have made money. But buying and holding for the long term when you’re in the middle of a cyclical period of deleveraging will simply not work. Remember, Japan is the global leader in using monetary policy and low interest rates to recover from an asset bubble and a debt crisis. You can see what that’s done for stock prices, and for investors.

Regards,

Dan Denning
for The Daily Reckoning Australia

From the Archives…

Why BHP Should Be Bracing Itself For a China Slowdown
2012-03-30 – Greg Canavan

What Does “the Market” Mean to You?
2012-03-29 – Joel Bowman

Why Australian House Prices Are Set to Crash
2012-03-28 – Dan Denning

Why US Manufacturing Could Be Made in America…Again!
2012-03-27 – Chris Mayer

The Best Real Estate Bets
2012-03-26 – Eric Fry

Dan Denning
Dan Denning is the Editor-in-Chief of The Daily Reckoning Australia and the author of 2005’s best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 as a small-cap analyst. From 2000 to 2005 he was the managing editor of Strategic Investment, where he recommended gold and warned of the US housing bubble. Dan has covered financial markets from Baltimore, Paris, London and, beginning in 2005, Melbourne Australia, where he is the Publisher of Port Phillip Publishing. To follow Dan's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.

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