How to protect your portfolio from central bankers’ mind games

Sir Mervyn King has an oft-quoted story about central banking. He talks about Diego Maradona scoring a particular goal.

He looked like he was going to move left, so the defenders reacted. Then he looked like he'd move right, so they reacted to that. And in the end, he scored by simply running in a straight line down the middle of the pitch.

I'm sure someone who's actually interested in football could give you a much more compelling rendition of that story, so my apologies to any fans out there.

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But the outgoing Bank of England governor's point is that a big part of a central banker's job is to manage expectations. What the market thinks you'll do is at least as important as what you actually do.

So the big question for this week is: what does Ben Bernanke want us all to think?

Ben Bernanke tries to do a Maradona

Why does this matter so much? Well, in case you hadn't noticed, the big slump in most stock and bond markets around the world is down to fears that the Fed is going to turn the money taps off by ending its quantitative easing (QE) programme.

At the start of this year, we'd hit a Goldilocks' moment. Growth wasn't strong enough to justify stopping QE. But it was good enough to justify rising stock markets.

But then Bernanke and other Fed members opened their mouths and hinted that it might be time to start thinking about possibly winding things down, depending on how the economic data panned out.

It's important to understand: all the Fed has done is suggested that it might pull back if the US economy looks like it's recovering. It's still manning the monetary pumps. There's still $85bn being shoved into the markets every month.

Yet the suggestion it would end has been enough to inspire a correction in most markets (that's a 10% fall), and send others into a bear market (a 20% or more fall).

So is Bernanke pulling a Maradona? Is he faking this move to tighten things up, just to keep markets on their toes?

The Fed has every excuse to keep the money flowing

Bernanke is probably the most famous student of the Great Depression on the planet. It's his view that the problem both back then and in Japan is that the central banks didn't do enough. Any time it looked as though they were going to succeed, they pulled out too early.

He's not going to take that risk, and he doesn't have to. The Fed has all the excuses it needs to keep monetary policy slack. Inflation at least by official measures, which is all that counts for Fed policy is really not a problem in the US. With commodity prices under pressure, you could even make an argument that deflation is a threat.

I don't want to get into a debate over the merits or otherwise of deflation here (though I'd argue that falling commodity prices are a good thing, and not to be countered by monetary policy). The point is, Bernanke is under no pressure to withdraw QE.

So having given over-exuberant investors a sobering reminder of the abyss we are all tightrope-walking over, I suspect the Fed will extend some words of comfort at its meeting this week. And if that's the case, then markets would probably bounce.

But we can't be sure. This is the problem with expectations management. Maybe the Fed doesn't think investors are scared enough yet. Or maybe now that investors have had a wake-up call, it'll take more than a few soothing words to get them to stop fleeing risky assets.

So what can you do? Simple. Don't get sucked into this central bank game-playing. Warren Buffett once said that the market is a voting machine in the short-term, and a weighing machine in the long run. So from day to day, it's all about how investor mood swings and fads affect where money is flowing to. But in the longer term, quality and value will out buy decent companies and assets at relatively cheap prices, and you'll make money.

On an individual stock basis, there are plenty of ratios you can look at to help you with this. For more on these, sign up for our free MoneyWeek Basics series of emails, which covers everything from price/earnings ratios to rebalancing and asset allocation.

On an individual market basis, one of our favourite ratios for measuring value is the CAPE ratio (cyclically adjusted p/e ratio). Buying a market when the CAPE is in single-digits usually means that in the long run, you'll make a decent return. This assumes that the private sector itself doesn't get nationalised, which, while rare, has happened in China and Russia in the past. My colleague Matthew Partridge looked at a couple of cheap markets in Friday's Money Morning.

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