INSIGHTS

On January 15, 2013

The 800-Pound Gorilla is Still in the Room

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The late Jim Croce was a wildly popular folksinger in the United States. His work included some of the sagest advice ever woven into the lyrics of a song. In his 1972 hit, “You Don’t Mess Around with Jim,” Croce gives a piece of advice that seems so obvious. “You don’t tug on Superman’s cape, you don’t spit into the wind, you don’t pull the mask off that old Lone Ranger and you don’t mess around with Jim.” Even as this song reinforces the idea that common sense should prevent behavior that is destined to fail, many people still choose to “tug on Superman’s cape.” Why would they do that when there is a strong probability that, by doing so, they will experience a high level of punishment? Could they possess a level of insight or knowledge not realized by the rest of the world, or are they simply rushing the Federal Reserve (Fed) because of what they wish to have happen? Maybe they are really financial masochists that somehow thrive on economic pain.

 

In the world of economics and financial assets, Superman’s cape belongs to Ben Bernanke. The Fed remains the “800-pound gorilla” in the room and continues to demonstrate that they are well in control of monetary policy and show no signs of changing direction. No matter the level of criticism, cajoling, or downright angst leveled against the sitting Fed chief, his resolve to continue record-setting Fed asset purchases continues. This radical behavior is seldom compared favorably to the 1979 Fed led by Paul Volcker who jacked interest rates up to 20% in the face of unemployment, cresting over 10% as well as a yield on the 10-year Treasury touching 15%. Back then, he was chastised by the politicians, the public and the media. Little did anyone know that his actions would later be widely credited for breaking the back of stubbornly high inflation (which peaked at 13.5% in 1981). It was the following year that a multi-decade expansion began for the U.S. economy, equity and bond markets. Volcker went from “wing-nut” to “wingman” and is now revered for his courageous actions.

 

Today, many view “Super Ben’s” actions as risky and reckless. I call them the “Lex Luthors” of market intelligence. As archenemies of “Super Ben,” they doubt that the Fed can achieve their stated objectives of encouraging economic growth and a meaningful reduction in unemployment. They worry that the intentions of the Fed to raise inflation expectations might get out of hand and return the United States to an “inflation nation.” Many strategists are leading their followers in the guidance that regardless of the Fed’s actions, true growth in the U.S. economy will be years off. They are a part of the “Japan Syndrome” crowd who believe that record debt and stagnation in the United States will lead to years of low economic output, consumption and growth. Finally, there are the “guns and gold” crowd who believe the Fed’s actions will destroy the dollar and the U.S. Treasury market, and they suggest hoarding food, gold and guns in your backyard bunker so you can successfully survive the aftermath. Who is right in this tug of war between “Super Ben” and the “Lex Luthors”?

 

If you look at who holds the ultimate upper hand in all things monetary, we note that the Fed has what it believes is an unlimited arsenal of firepower. The ability to create currency and deploy it in an effort to increase aggregate demand is a huge force to be reckoned with. Record-low interest rates and liquidity have spurred a doubling of equity indices and reversed a housing plunge since the bottom in 2009. As we watch “Super Ben Bernanke” clean up “Metropolis,” we are reminded of what happened to Lex Luthor. As in the story about Superman, “Super Ben” is likely to prevail because he has the greatest power.

 

The late George Santayana quipped that “those who don’t know their history are bound to repeat it.” Fighting the Fed through history has never ended well. The Fed is now more transparent and resolute than at any time in history. They are telling us that they will continue to keep rates at zero and continue buying assets until they have reached their goals. History tells us that it is always better to bet on them achieving their goals rather than against them. Unlimited power has unlimited potential. If “Super Ben” is attempting to drive dollars out of high-grade, low-yielding investments and into equities, then the winning place to be is where the money is going, not where it is coming from.

 

There is a great deal of discussion about what will be the catalyst for the rise in equity prices. The “Great Rotation,” as it is being called, is already underway and the stage is precisely set for it to play out. Market participants have withdrawn over a trillion dollars from the equity markets in masses over the past few years. They have jammed every dime into cash and bonds at record-high prices and low yields. It appears to us that this has all the trappings of a market top. All of these actions being engaged in by seemingly prudent investors – even as the Fed seeks to create aggregate demand and raise inflation expectations. If successful, the Fed’s actions will increase the prices of risk assets and reduce the future expected returns on bonds and cash. This is precisely where the concentration of money is sitting right now. People who have sought the safety and shelter of the bond and money markets are right in the crosshairs of “Super Ben.” As it becomes apparent that “Super Ben” will win, those assets will become the gunpowder for the demand in equities.

 

Last week we saw the first net-positive flows for equities in a very long time. At the end of 2012, we began to see outflows in the bond markets. Could this be the capitulation of the “Lex Luthors”? We know that our view is a contrarian one, but we feel strongly that capital will always eventually seek positive return profiles over negative ones. We feel that as the “800-pound gorilla” Fed continues to prosecute its plan, it will become obvious to the markets where those optimal returns will be. What seems to be radical behavior now will likely become the stuff that is canonized in financial history. Just like Paul Volcker’s Fed slew the inflation giant of the 20th Century, Mr. Bernanke’s Fed will likely defeat the deflation giant of the 21st Century.

The moral of this story should be obvious: don’t tug on “Super Ben’s” cape. Allocate assets ahead of the Fed’s move. Money is hunting for yield. It is becoming less shy about finding it. Equities should be the clear winner here. We are seeing the dividend yield of the S&P 500 higher than the 10-year Treasury. We believe that is a signal to capital owners that dividends are a better value and should be bought. “Super Ben” will again bring order to “Metropolis” and the city where you live as well.

 

 

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at ~/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com