In mid-June, Fed Chairman Bernanke gave a press
conference in which he discussed the conditions for
tapering back and eventually ending monetary easing. The
bond and stock markets reacted with a paroxysm. Markets
worldwide sold off feverishly. In truth, we were
surprised at the ferocity of the moves. Where was the
new information to make markets move? Why the surprise?
Many, including ourselves, had been writing for a good
deal of time that bonds were vulnerable to rising
interest rates as the Fed was unlikely or unable to keep
rates artificially low forever. It is striking that the
markets did not better discount this inevitability.
Soon after the press conference, members of the Fed
were rolled out, one by one, to assuage investors with
calming assurances that monetary easing was contingent
upon the economy and employment growing more robustly.
The implied idea was that if the economy got strong
enough, it would support the stock market even in the
face of rising interest rates. Indeed, the recent,
encouraging employment figures suggest that this may be
the likely outcome. For the time being, the coordinated,
full court press has quieted the markets’ nerves.
There seems to be a consensus that the economy will
begin to accelerate into 2014 and unemployment will
continue to trend down, a good thing. But noticeably
absent (despite the easy money policy at the Fed) is the
willingness of companies to buy more machinery and
expand capacity, that is, to increase capital
expenditures. Instead, many have been buying back large
quantities of their own stock. This boosts earnings per
share, rewarding shareholders, even though revenues and
aggregate profit growth are sluggish. Others are raising
dividends, providing more up-front cash income for their
investors. Apple recently borrowed a huge amount of
money at record low rates in order to pay a large
dividend to its stockholders. This is good for investors
but provides limited stimulus for the real economy,
which as a result is likely to grow more slowly than in
The question of the day is: How is the Fed’s easy
money policy working? The answer: Not so well. The Fed
has been buying government and mortgage debt in
unprecedented size from the banks in order to keep
interest rates low. The cash that the banks get from
selling to the Fed is supposed to go towards increased
loans. However, a combination of slack corporate demand
and higher credit standards particularly for mortgages
has created a situation where excess liquidity does not
circulate through the economy. Regulatory issues and an
excess of caution (the banks have been demonized for
poor risk management) have contributed to slow loan
growth. Consequently, the banks deposit their excess
cash at the Federal Reserve instead of lending it to
business and homebuyers. This is what John Maynard
Keynes called the “liquidity trap.” Despite the low
level of interest rates, a combination of a limited
availability of credit and a limited demand for credit
has restricted growth.
Between last November and May of this year, stocks
and bonds rallied smartly as stimulus meant for the
economy went into financial assets instead. After a
sharp selloff in June, stocks have recovered to their
May highs while bonds remain depressed, taking their cue
from a perceived shift in the Fed’s easy money policy
noted above. In order for stocks to continue higher,
corporate revenue growth will have to accelerate. This
will require a faster growing economy. A failure of the
Fed’s easy money to stimulate growth would be bad for
the stock market. We are in uncharted waters. Be
prepared for more market paroxysms.
Meanwhile, bonds continue to be unattractive.
Interest rates are unnaturally low (and prices
unnaturally high) due to the repression of rates to
artificially low levels by the Fed’s easy money policy
(Fed buying pushes up prices thus lowering yields).
While rates may rally or sell off from these levels in
the short-term, the long-term trend is up and bond
One puzzling and interesting development during the
previous quarter is the sharp sell-off in gold and the
absence of inflation despite the unprecedented printing
of money by the Fed. One observation is that inflation
has been constrained by the long-term trend towards
globalization, which has directed economic activity to
countries that have lower labor costs. This benefits
consumers and constrains inflation by keeping prices
low. Walmart could not offer "Every Day Low Prices"
without free trade.
That inflation has remained low is also due to excess
capacity in labor markets, which keeps wages low. So
far, the unemployment rate remains stubbornly high and
the percentage of the population that is working is near
historic lows. There is currently no fear of wage
inflation in the US labor markets.
Since November 2012, gold has declined 30% but we
believe it is still in a long-term bull market. There is
a precedent for this. In 1975-1976, gold fell 50% from
$200/oz to $100/oz before surging 800% in the ensuing
years as inflation came surging back. We are not
suggesting such a surge in gold again. However, we do
believe that eventually the Fed’s unprecedented printing
of money will be reflected in higher inflation and a
higher price of gold in the not too distant future.
Investors should not sell gold or gold mining shares at
Please read our important notice
about these letters and the securities they mention.