How to avoid having your brain scrambled by the Federal Reserve

The four most dangerous words in investing are ‘it’s different this time’.

This piece of financial advice – made famous by Sir John Templeton – is so well-known that it’s a cliché. Everybody knows it. 

Yet when push comes to shove, almost nobody pays attention to it. My reading pile is currently full of ‘yes but, it really is different this time’ articles.

That’s a danger sign. It’s a warning that investors are getting caught up in the hype of a bubble.

And so today I’d like to look at how you can keep your head when all about you are losing theirs.

Why City investors are so confused

This morning I waded through excerpts from a pseudo-intellectual note from a fund manager, posted on the FT Alphaville blog.

Apparently, “the efficient frontier is now contorted to such a degree that traditional empirical views are no longer relevant.” That gives you a flavour of the general tone.

In any case, via some tortured analogies, he arrives at the conclusion that the Federal Reserve is making it very hard to understand what anything is really worth.

The upshot was that investors can’t rely on the old rules anymore, because the Fed has turned things on its head.

Central bankers are trying to convince us all that the economy is in better shape than it really is, by artificially inflating asset prices. This in turn is distorting and mis-shaping the ‘real’ economy. This is making it nigh on impossible to work out what’s risky and what isn’t.

It’s hard to disagree with this assessment. But what’s new?

Politicians and central banks have always interfered in the market. The whole bull market of the ‘80s and ‘90s was aided and abetted – maybe even created – by central banks and politicians.

From ‘big bang’ to constant fiddling with interest rates and tax rules – there was plenty of intervention during those decades. It was just that it was the kind of intervention that the market liked. It was pouring fuel on the fire, adding vodka to the punchbowl.

All that’s changed now is that instead of being in a bull market, we’re in a bear market. The Fed’s main goal – to keep the party going – is no different. But before, the central bank was pouring petrol on a roaring patch of dry kindling. It wasn’t hard to encourage the flames to go higher.

Now it’s trying to ignite a sodden bale of tightly-packed straw in the middle of a monsoon. That’s more of a challenge. But while the tactics have changed, the goal hasn’t. The Fed (and its fellow central banks) are trying to short-circuit the uncomfortable deleveraging process and go back to the bubble-blowing era.

The way they’ve chosen to do this, is by blowing up a bubble in the bond market. And this is what is scrambling otherwise highly intelligent people’s brains.

The bond market is in a bubble

You see, if you have been subjected to an education in theoretical finance, then you think of the bond market as being ‘risk-free’. (For more on how this works, see my colleague Tim Bennett’s video on the topic: Warning: the City’s formula for pricing shares is bust).

Whatever rate you can get by investing in US government bonds is the ‘risk-free’ rate. So that’s also the price you use to calculate what the price of other assets ‘should’ be. After all, if you can get 1% ‘risk free’ in the bond market, then you should demand more from something riskier, like equities.

So when the Fed wades in and starts driving bond yields lower artificially, it messes up all the calculations that these people normally do. Suddenly, no one knows what the price of anything should be, because the ‘risk-free’ rate has been so badly distorted.

No wonder they’re all having existential crises.

The nice thing about working outside the City is that you’ve probably avoided this indoctrination. So you can see that this is all nonsense.

Government bonds – of any government – aren’t ‘risk-free’. Bond prices can suffer very nasty falls if the wrong conditions arise. Sometimes they are expensive, and sometimes they are cheap.

Right now, prices of bonds are at “unprecedented” highs. And something very simple happens when a price reaches an “unprecedented” high. It falls.

It might not fall right away. It almost certainly won’t fall just because you have noticed one morning that the price is ‘unprecedented.’ But it will fall eventually. Most likely at the point when everyone is convinced we’ve entered a “new paradigm”.

That’s why market timing is not the road to riches for most of us. Because we’re terrible at it. We sell too early, then we buy too late, and then we sell too late.

This is why, of all the methods of investing out there, we like value investing best. You buy what’s cheap and hated, and avoid or sell what’s expensive and loved.

If you do this, then in the short-term, you will have to endure the psychological pain of holding assets that no one likes, and rejecting ones that keep going up. And this psychological pain does not stop.

When the assets you avoided eventually fall off a cliff, no one wants to hear “I told you so”. And when the cheap assets that everyone hated turn into expensive assets that everyone loves, you’ll be selling, just as everyone else is buying.

All you have as compensation is the knowledge that you’ll hopefully make enough money to enjoy a comfortable retirement. We suspect that’s compensation enough.

We looked at what we think is cheap and what’s expensive in a recent cover story. Examples of cheap assets include European and Japanese equities. Examples of expensive assets include bonds of almost all stripes, and industrial commodities.

And don’t worry about second-guessing the Fed or other central banks. But take out insurance, in the form of gold, in case the entire system implodes when this grand monetary experiment gets completely out of hand.

This might sound simplistic. But it’s not – believe me, it’s hard enough trying to work out which assets are cheap, without grappling with mind-bending ‘new paradigms’.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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9 Responses

  1. 10/10/2012, K.I.S.S. wrote

    “So when the Fed wades in……… bond prices lower” When did they last do that?

  2. 10/10/2012, Ellen wrote

    Thank you for this insightful article. You are right that it has become very difficult to make a judgment on what to invest in, with so much market manipulation going on with interest rates, QE and bailouts. Governments policies are about protecting the system rather than it’s citizens and everything could change very quickly as soon as the banks are adequately recapitalised. Investors may well be part of this recapitalisation program and may be being channeled into a pen, the way a sheep dog steers his sheep. I certainly sometimes feel as clueless as one of those sheep!

  3. 10/10/2012, Beta adjusted wrote

    Last I saw (a few months ago) in a study by Barcap strategist Edmund Shing (recommended, he does some very interesting stuff!) did a nice backtest and showed that simple value investing still worked very well in Europe and the UK throughout the crisis, and worked even better when you used a quality and momentum screen filter. So yes, absolute value is impossible to gauge (what is the long-term discount rate to use in the DCF?) but relative value has still been working well! Stock correlations have spiked but over relatively short time-periods of panic after which they have then fallen again.

  4. 10/10/2012, simpleton wrote

    KISS – I think John had the word ‘yield’ in his head but wrote ‘prices’ instead – a typo

  5. 10/10/2012, Chris B - Nr. Slough UK wrote

    I agree entirely about the problem with putting a value on anything, with all the QE distorting matters. I think now more and more people can see that this will all end in tears. The risks of hyperinflation are also underplayed. To true worth of currencies seems also to be shrouded in mysticism. When the first country defaults I imagine many Bonds becoming worthless bits of cyber paper! The problem is how long will they be able to keep inflating the bubbles? The markets are already defying gravity and could fall faster than Felix Baumgartner when the bubbles burst.

  6. 10/10/2012, Brian, Marple wrote

    John,

    Great article.

    I guess no commentator will dare use the phrase “a new paradigm” as they know it is loaded. I wonder what the euphemism will be?

    The bubble will keep going for longer than anyone anticipates – they usually do.

    Lots of new retail bond issues makes me a little worried – is this the equivalent of a newly launched unit trust “theme” fund – usually a good indicator that a fast rising investment class has reached its sell by date? My corporate bond holdings have been doing well recently and it must be time soon to think of selling.

  7. 10/10/2012, Moderator wrote

    K.I.S.S. – thanks, you’re right. It should be ‘yields’, as simpleton says. We’ve changed it so it makes sense.

  8. 10/10/2012, IWAE wrote

    John, do you really believe that EU equities valuations of today would survive a € meltdown ? Is the risk of € collapse fully in today’s prices? And why do you think that Japan is cheap? Their stockmarket has had 20+ years of poor performance – is this about to end?

  9. 10/10/2012, DrGrumpy wrote

    I also read that article on FT Alphaville. Ordinarily I find a bit of alternative philosophy quite interesting, but I think that the FT may be losing its grip on reality. It sure was a complicated way of saying fundamentals aren’t relevant any more. It seems that the intellectual press just can’t say anything in plain english, otherwise the rest of us might realise that its all a sham.

Commenting on this article closed

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