Valuation-Informed Indexing #121
by Rob Bennett
Investors often complain that the Federal Reserve should not be injecting liquidity into the U.S. economy for the purpose of propping up stock market prices or even for other purposes in circumstances in which the likely result is a propping up of stock market prices. The market needs to work toward the proper price level on its own, the argument goes.
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
But the case both for and against Federal Reserve interventions changes with the shift from the Buy-and-Hold Model for understanding how stock investing works to the Valuation-Informed Indexing Model. I think it is worth exploring the differences.
The Buy-and-Hold Model posits that stock price changes are caused by economic developments. Federal Reserve spending is an artificial economic stimulant. The belief is that Federal Reserve spending can be effective in the short term in keeping prices high but that the money used for the Federal Reserve spending is taken from somewhere else and thus the positive effect is cancelled out. Since it is the Fed choosing winners and losers rather than the market, and since this results in distortions, the net effect is a negative.
The Valuation-Informed Indexing Model posits that stock price changes are caused by changes in investor emotion (economic developments can of course serve as catalysts to changes in investor emotions). If this is so, Federal Reserve spending can in many circumstances not only prove to be less than effective; it can achieve the opposite of the desired result.
Say that stock prices are falling because investors know in the back of their minds that stocks have been overpriced for a long time and that the gig is just about up. In those circumstances, a sharp price drop might satisfy investors that prices had fallen enough and the price drop might stop at a reasonable place. However, artificial stimulants aimed at insuring that the price drop does not get out of hand might further alarm investors who are already concerned that prices drops are coming.
The Fed sends a message when it intervenes in the market. The message is — Things are bad, worse than most people appreciate. Fed interventions are not the norm. A message that special measures must be taken is emotionally upsetting, perhaps more upsetting than the price crash that is being avoided.
Say that there were signs that you were at risk for a heart attack. You put off going to the doctor for a long time. But your shortness of breath eventually became so pronounced that you made an appointment. Now say that the doctor gives you bad news — you need a bypass.
That’s going to upset you, there’s no getting away from it. But the full truth here is that, if you have been putting off the appointment for a long time, you already knew on some level of consciousness about the need for a bypass. So the news might not really be that bad of a hit. It might even come as a relief. When you go into denial, your silenced fears can get the worst of you. You can build up expectations so dire that even hearing that you need a bypass might be perceived as positive message compared to the fears you had come to entertain.
Now say that the doctor responds not by saying that you need a bypass but by saying that he cannot at the moment tell you where things stand. Why is he holding back? Things must be really bad! Perhaps things have reached a point where even a bypass won’t help. The doctor’s decision to avoid scaring you can cause a full-out panic.
I worry that this is the sort of dynamic we are creating with our economic crisis. Most of us think that the crisis is coming to a close. Times have been hard. But not too awfully hard. A common feeling today is that there are going to be bad economic times now and again but that at least we have survived this hit and it appears to be nearing an end.
Hidden beneath that surface emotion is a worry that perhaps the crisis is not really nearing an end. Any sign that that is so could cause a second price crash. Any sign that the crisis is returning in full force could cause panic.
I believe that that is why the Fed is acting to reassure investors. The thought is perfectly rational — It’s better to spend some money preventing a panic than it would be to spend the large sum it would take to recover from the panic. I do not believe that the Fed is responding primarily to political pressures. I believe that there is a sincere belief that intervention is sound policy. I believe that there is a concern that other forms of government intervention have not worked and that we need to take some extreme measures lest things unravel.
The core problem remains the level of overvaluation in the stock market. Investors can never develop a sustained confidence in the market until we hit much lower price levels. There has never been a secular bear market that ended with price levels anywhere near those that apply today. I believe that most investors “know” this on some level of consciousness (in a general way, not in the particulars). Thus, we will not see a sustained bull market without first seeing much lower prices. Investors just cannot shake their worries until things get much worse.
If prices were to fall to fair-value levels (a drop in the P/E10 level from the low 20s to 15), that might be enough to calm investor fears for a time. Prices might be able to stabilize if we saw a significant but not dramatic price drop. But investors will feel uneasy in response to policies that bring on no price drop whatsoever. The emotional reaction will be disbelief, the emotional reaction will be a “this is too good to be true” feeling.
It’s by holding prices up that we are causing them to fall harder than they would otherwise need to fall. It’s by desperately trying to avoid panic that we are increasing the odds that we will see a panic.
There’s one thing that would buck up investor confidence. Straight talk. We have to let investors know that they are going to lose more money. Only then will they believe that we are on our way to again having a stock market that can produce lasting gains.
The Fed is engaging in behavior intended to strengthen confidence. But the very fact that it is engaging in acts that would not be taken except in extreme circumstances is sending a signal that emotionally sensitive investors (and we are all emotionally sensitive investors today!) will likely interpret as a sign that things are worse than they have up until now permitted themselves to believe they were. Policymakers need to learn that trying to force emotional reactions is a delicate and dangerous sort of business.
Rob Bennett has written about how common-sense investing became so controversial. His bio is here.