July 2013- The Easy Money Policy and its Effects

By The Lerner Group on July 1, 2013

Last week all of us witnessed a live example of the comment that “No good deed goes unpunished.” Ben Bernanke made a thoughtful and constructive speech. As a direct consequence of his remarks, bonds and stocks immediately fell in price.
Our economy was in a recession during the second half of 2008 and the first half of 2009. Since then, the economy has steadily improved. The Standard and Poor’s Case-Shiller Index reported that home prices in March rose 10.9 percent from a year ago, the largest such gain in seven years. The net worth of U.S. households rose 4.5 percent in the first three months of the year to $70.35 trillion, the highest level since 2007. American employers took on more workers than forecast and payrolls increased 175,000 in May after a revised 149,000 increase in April. Retailers reported that their sales were starting to “thaw” from a cold winter. In addition to these positive economic developments, consumer prices continued to rise. Tuition payments, whether for pre-school or college, rose sharply over the past few years, as has the cost of a salad at a restaurant; the same luncheon salad which used to cost $4 to $5 may now command $10 to $14.
The driving force behind all of these recent developments has been the easy money policy of the Federal Reserve. Not only has the money supply increased at double digit rates since 2008, but short term interest rates were held to near zero.
The Federal Reserve recognizes the positive economic facts just cited and Ben Bernanke delivered a largely uplifting message: the economy was getting strong enough to stand on its own. The Wall Street Journal said “seeing a stronger economy in the months ahead, Chairman Bernanke set out a tentative time table for the Fed’s pullback from its latest bond buying program, launched last September, to push down long term interest rates, buoy asset prices, and encourage economic growth. The Fed said it could start reducing its monthly bond purchases later in the year and end them altogether if the economy picks up as expected.” Other Fed Chairmen implemented similar policies when they found themselves in comparable situations. One famously said that it was the Fed’s job to “lean against the breeze”, i.e., tighten credit when conditions are good and ease credit when conditions are more difficult; another said his job “was to take away the punchbowl just as the party gets going.”
If the Fed is right in its belief that things are going well in the economy and we can have a sustainable prosperity without printing new money at a double digit rate of increase, why did the prices of stocks and bonds fall? I believe the drop occurred because many investors are short sighted, fail to read or listen very carefully, and react emotionally rather than thoughtfully. This not something new; a very popular stock market book called “The Madness of Crowds” was first published in 1841 and commented on widespread stock price movements of that day.
When Bernanke said that the economy was getting stronger and implied that very low or zero interest rates could cause more long term problems than a more market sensitive interest rate, many people just heard that interest rates were going to rise. They concluded that their bonds and stocks would fall, and to protect their wealth they should sell immediately. But the questions then arose, “To whom should they sell? Who is buying?” Many market makers were content with the size of their current holdings. If someone wanted to sell his or her holdings at, say, five or ten points below the last trade, the market makers could consider helping the seller out by buying their holdings from them. The market makers were willing to buy because they could look forward to making a profit on that trade by selling at a higher price over the next few days and weeks.
Our response to Bernanke’s press conference remarks that the economy is improving and, by inference, profits can increase, is to review all of our accounts and make two judgment calls. The first is to determine whether the cash flow your total assets generate is adequate to meet your needs. This is a personal decision which you alone can answer; we welcome hearing from you about your cash flow needs so we can make appropriate change in your portfolio allocation. The second judgment call is to ascertain which sectors of the market could benefit the most from the opportunities which the recent price drop offers. We think that one such sector embraces small cap value companies that now sell for low price earnings and low price to book value ratios; we plan to begin adding names from this sector to your account.
Our goals remain as always, to preserve and enhance your wealth over time. To satisfy these goals, we think it is important that we stay in touch with you and through regular communications. These letters are one such communication vehicle. We recently received the suggestion that we e-mail these letters to you rather than sending them via snail mail. If you would like to receive your copy by e-mail, please send Maureen your e-mail address at mcarney@HighTowerAdvisors.com. A second communication vehicle is our monthly meeting where we discuss with clients and friends recent trends in the economy and the market. If you have an interest in attending such a regular monthly program, please call and we will extend an invitation.