Fed Policy: What’s Your Exit? by Axel Merk, Merk Investments

Are you prepared for an “exit”? If the Fed pursues an “exit” from ultra low interest rate policy, are you prepared for an exit from the stock market should things turn South? We discuss how investors prepare, noting the most common mistakes investors make along the way.

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Are you prepared for an exit?

No, you are not. We know because we meet investment advisers that have dropped their defensive strategies because they were losing clients. Those we meet that say they are prepared think they can get out at the right time should the markets topple over as the Fed exits; our guess is pigs will learn to fly before many will get that timing right. And those who don’t rely on luck are the first to tell us they don’t think they are fully prepared, as it’s rather difficult to predict how things will unfold.

Should you prepare for an exit?

There’s a group of investors that say an “exit” is ludicrous – there’s no way the Fed will pull off an exit.

It turns out we sympathize with that view, but think getting ready for a Fed exit is still paramount. As I wrote in my book Sustainable Wealth, a prudent investor plans for different scenarios. Any scenario that has a non-negligible probability with a potentially profound impact on one’s portfolio should be taken into account. We don’t really have to go much further than this, as all we have to do is look at today’s market: in today’s markets, risk premia are highly compressed. This may sound academic, but what it means is that investors downplay the risk embedded in risky assets. We can see that through investors bidding up junk bonds and buying debt of weaker Eurozone countries. We can also see it in the stock market, where volatility is lower than what has historically been considered normal (i.e. the VIX index is at an unusually low level). In plain English, this means markets may be priced to perfection. And that’s where the problem is: the world isn’t perfect. As such, just the hint of a Fed exit might cause havoc in the market, even if it is never actually pursued. Please read ‘Instability the New Normal’ for an in-depth analysis on how this may unfold.

Five common mistakes investors make

The much more difficult question is how does one prepare in earnest for an “exit.” After all, any strategy not fully invested in the stock market appears to have under-performed. What not to do is a lot easier to say than what to do. Five common mistakes investors make:

• Feeling like you’re losing out because you’re not keeping up with the stock market. No: you should develop a financial plan tailored towards your circumstances. You should not care how much the guy or gal next to you, or the “market” makes.

• Feeling like you haven’t saved enough for retirement and as a result should invest in the stock market to make up the shortfall. No: Warren Buffett got to the point when he said: “The stock market has a very efficient way of transferring wealth from the impatient to the patient.” The prudent investor waits to find good values; the impatient investor is bound to invest at the top by chasing trends.

• Feeling like you can’t invest more because you don’t make enough money. For most, spending, not income is the problem. Remember the days back in college when you could live off very little? Spending $80 a month on a phone bill is a luxury, not a necessity.

• Not spending any time researching investment options. Many spend more time researching which HDTV to buy than researching an investment. Just because you can buy the world with a push of a button, doesn’t mean you should. You worked hard to earn those savings; now spend a little time researching what to do with your savings.

• Not understanding true diversification. Diversification is not about labels, but correlation. When policy makers are very engaged in the markets, asset prices may no longer reflect fundamentals, but instead reflect the next perceived intervention by policy makers. In practice, this has meant that many investments have been highly correlated in recent years. Differently said: if everything has gone up in your portfolio of late, you have a problem.

How do you prepare for an exit?

All successful investment strategies I have encountered have in common that they are based on a plan. A plan that takes into account where one comes from, where one is planning to go; how one intends to get there, with appropriate checks along the way. If this sounds obvious, you would be surprised how few are adhering to these basic principles. And why would I mention these basic principles in the context of a Fed exit? Two reasons: first, one should not lose sight of basic investment principles in addressing any one situation; and second, the best of plans are impacted when others are not living up to their part of the bargain. What I’m referring to is that the Fed – which arguably has a profound impact on asset prices – does not appear to follow those basic principles in conducting monetary policy. The only thing we really know about the Fed’s so-called exit is that Janet Yellen would like to keep monetary policy accommodative to help the convicted felons get a job (as discussed in her first policy public speech since becoming Fed Chair). This characterization may sound unfair, but it’s the simplistic conclusion I have to draw when given her focus on employment, her expressed desire to help ‘Main Street,’ the fact she has never pushed back when being labeled a dove, and her rejection of a rules-based framework to monetary policy.

That said, let’s address these basic principles in the context of an exit:

Where we came from: This did not start in 2007 or 2008, but has long been in the making. For in-depth analysis over the past 10 years, please read up on our Merk Insights. For purposes of today, we shall note that investors were burned in 2000, as well as in 2008; wages for many have stagnated. We have endured years of low interest rates, making it difficult if not impossible for many pensioners to live off the income generated by their fixed income investments. Many investors have moved to embrace a riskier mix of investments than they are comfortable with, but stick with their allocations as long as they don’t get burned. To us, this increases the odds of a crash, as those investors may not stick around when the going gets rough.

However, we know a few things about this journey: geopolitical tensions have been rising. In ‘Instability the New Normal’, we argue that this is a symptom of the times as policy makers blame minorities, the wealthy, and foreigners when they have trouble balancing the books; rarely ever do they blame themselves. Government deficits are not sustainable; yet, there might not be enough wealthy to tax, either.

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