Are Stock ETF Investors Placing Too Much Faith In The Fed?

By Gary Gordon, MS, CFP® | July 30, 2014 AAA

“The contraction in the first quarter is not reflective of the underlying state of the U.S. economy and the subsequent flow of data points to a significant snap-back in the second quarter,” explained the chief economist at Regions Financial. Keep in mind, Richard Moody, like the overwhelming majority of economic pundits, projected rising interest rates in 2014. Not only has the 10-year yield dropped a whopping 50 basis points, but investors who counted on the popular sentiment missed out on the most successful asset class for the first half of 2014 — longer-term bonds.

Mr. Moody may or may not have led you astray, but he certainly was not alone in believing that rates could only go higher. And he certainly is not alone in believing gross domestic product (GDP) will “snap back” in the second quarter. However, Mr. Moody may have a problem. For one thing, inflation-adjusted spending declined over the last few months. That cannot be a strong sign for the U.S. where up to two-thirds of economic growth depends on consumer expenditures. What’s more, scores of Wall Street firms have revised their second quarter estimates downward. Barclays slashed a 4.0% expectation down to 2.9% whereas RBS sliced its target down to 2.2% from 2.7%

Should second quarter growth approximate 3.0%, the increase would certainly constitute a rebound. That kind of number would validate Mr. Moody’s conviction. Yet few have even bothered to question the evolution of how bullish commentators changed their rationale for the disastrous 1st quarter results. Two months ago, it was the weather’s fault. One month later, the data had been revised lower, and commentators expressed that backward-looking data has limited value. After the third revision of GDP served up an abysmal contraction (-2.9%), bullish economists began talking about the “bounce-back.” Anything to justify rising asset prices?

Personally, I am still wondering whether or not investors even care what our economic path is. If stocks can actually rally on the day that we learn that the economy sharply contracted (-2.9%) in the initial quarter of 2014, why would it matter whether we see GDP estimates of 2.0%, 2.5% or 3.0% for Q2? Investors have placed their complete faith and trust in the world’s central banks to keep rates subdued for years to come.

Perhaps ironically, if you happen to be one of those with a yen for a stock correction, you should hope for a 4.5% Q2 growth rate. That way, the Fed might find itself more likely to raise its overnight lending rates sooner ratter than later, giving investors reason to question holding overvalued U.S. equities in a perceived cycle of tightening. Or maybe you should root for a 0.5% GDP reading. Such an event would throw the idea of recovery into complete disarray, pushing U.S. stock investors to reevaluate the rationality of their exuberance.

Is a second quarter reading as low as 0.5% really possible? Probably not. Then again, you cannot even find previous forecasts for Q1 at “negative 2.9%.” And all of the economists were well aware of the exceptionally odd weather patterns.

Even worse, the brightest minds in the world missed the 2008 recession completely. All that one has to do is to look back at Federal Reserve meetings from 2008. Each of the committee members had extraordinary confidence that the Bear Stearns bailout earlier in the year marked the lowest ebb for risk assets as well as the economy. In June of 2008, Janet Yellen expressed that strong spending data eased her fears about the onset of a recession. She also anticipated raising fed funds overnight lending rates starting in December of 2008. (Note: Chairman Bernake’s Fed went in the opposite direction instead, ushering in zero percent rates and emergency “QE” stimulus.) Similarly, committee member Lacker felt that the outlook for growth had edged up and that risks of a serious recession had receded. Meanwhile, member Bullard believed that the committee should down-weight systemic risk concerns going forward.

Think about it. A minority of folks (myself included) went on record to say that a recession is a near-certainty as early as January of 2008. Meanwhile, smarter men and women — folks who are responsible for monetary policy that affects the entire globe — believed the economy was on track for success in June of the same year. They believed they had solved the world’s financial woes and, by extension, economic uncertainty, with the bailout of Bear Stearns. Yet as late as June of 2008, the Fed had no idea that the precipitous decline in housing prices/sales coupled with the sub-prime drama playing out on Wall Street had the power to send the global economy into a tailspin.

The point of this commentary is merely to stimulate thought. Are we placing too much faith in central bankers? And at what point might we want to consider the possibility that a significant institution (e.g., Federal Reserve, Bank of Japan, European Central Bank, etc.) could make a serious policy mistake?

Here is the way that I’ve been managing the above-mentioned risks with clients of Pacific Park Financial, Inc. I have been reducing the duration of longer-term high yield bonds, since they often move in the direction of stocks. There is plenty of yield in shorter-term high yield ETFs like SPDR Barclays Short-Term High Yield (SJNK) and PIMCO 0-5 Year Short-Term High Yield (HYS). Simultaneously, since the beginning of the year, I have increased the duration on investment-grade U.S. Treasuries and corporate credit. Not only has it been highly profitable to shift toward funds like Vanguard Long-Term Bond (BLV) and Vanguard Extended Duration (EDV), but these ETFs act as a safer haven in times when the stock market is reeling.

Next, searching for stock ETFs with better fundamentals in an environment where the monetary authorities are increasing their stimulus measures has been a recipe for success since 2009. For example, the European Central Bank (ECB) is on target to continue lowering rates and/or provide unconventional measures to battle regional deflation. Granted, the ECB could easily make a policy misstep along the way, and the eurozone itself could struggle to break recessionary pressures. On the other hand, selecting European assets that offer higher dividend yields and trade at significant P/E discounts to comparable U.S. equities may act as a buffer to widespread selling. I continue to favor ETFs like iShares MSCI EAFE Value (EFV) and WisdomTree Hedged Europe Equity (HEDJ).

Finally, there’s simply no substitute for recognizing the power of probability. Perhaps U.S. stocks in the S&P 500 can continue to trade above a 200-day moving average for much longer than 400 days; it broke the record of 385 days a few weeks ago, but maybe it can run for 500 days. And 32 months without a correction may just be marking the end of the 2nd period in a Stanley Cup Final; we might be setting up for a run at 48 months. Nevertheless, intelligent ETF investors should be mindful of the many techniques in their toolbox for insuring a portfolio, including stop-limit orders, trend analysis, hedging and/or put options. Holding-n-hoping is only a “plan” for those who lack knowledge about mathematics, the psychology of human beings and the history of market benchmarks.

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