Last August, as the Federal Reserve was preparing to embark on its next monetary policy strategy, Operation Twist, I wrote about its potential consequences in the column, The Honey Is Gone.
Yesterday, the Federal Reserve announced its intention to extend its zero-interest-rate policy (ZIRP) until the end of 2014. In his Q&A period that followed the announcement, Chairman Bernanke went even further by indicating that he did not foresee interest-rate increases until sometime in 2015. Equities and sovereign bonds in the U.S. immediately rallied on the announcement, and I think it's important to understand why.
Fed chief Bernanke said the Fed is extending ZIRP, but the markets heard this: "We are expanding quantitative easing." ZIRP and quantitative easing are not the same thing. Stocks and bonds went up without the Fed having to deploy any more stimulus plans or even promising to do so. In that sense, the Fed chairman was successful in tricking private capital into a risk-taking mode without incurring any costs of its own. The Fed is now using force and subterfuge to get private market participants to take on risk.
ZIRP destroys savers' ability to earn income on savings accounts, money markets, and other short-term vehicles, forcing them to move further out on the bond yield curve and risk-taking in search of income. Quantitative easing and Operation Twist are used to force private investors even further out on the yield curve and from bonds into dividend paying stocks in search of income.
The original rationale behind "don't fight the Fed" was that monetary stimulus would reduce the cost of capital, thereby encouraging economic activity that would drive up corporate revenues and earnings and justify higher stock prices. However, it is quickly morphing into being perceived as a direct support for equity and bond prices; irrespective of whether or not it results in an increase in economic activity.
The logical question that investors will begin to ask and consider shortly is: In such an environment, how is real risk and fair value determined for any equity issue?
Last year, the Joint Select Committee on Deficit Reduction failed to deliver an agreement on budget cuts, triggering automatic budget cuts that government contractors are taking action on now.
Throughout the Washington, D.C. metro area, large and small government contractors are beginning to cut staff as federal contracts are being canceled or postponed. Yesterday General Dynamics (GD) announced that its revenue and earnings are falling as a result and are expected to fall further. And yet GD's stock price has increased about 30% in the past four months.
And the five largest federal government contractors have experienced similar results. Lockheed Martin (LMT) is up about 17%, Northrup Grumman (NOC) about 17%, Boeing (BA) about 30%, Raytheon (RTN) about 25%, SAIC (SAI) about 14%.
Although some of this action is certainly attributed to increased tensions with Iran the stock price increases have been steady and in line with the market overall in the past four months.
The common theme for all U.S. equities is Federal Reserve intervention. The markets appear to be pricing almost exclusively off of expectations of continued monetary stimulus with traditional fundamental economic and corporate specific metrics having little to no bearing any longer. Further, there is a growing appearance that the Federal Reserve, rather than discouraging such expectations of corporate welfare, is actually encouraging them.
Last year, Goldman Sachs suggested that the Federal Reserve should consider moving from quantitative easing and duration extension to nominal GDP targeting, which would essentially increase the monetary base until economic activity increases. Extending ZIRP by about two more years is a step in that direction, but it also appears that the Fed may be targeting equity values directly now -- although I doubt the members would ever admit it.
All of this puts the concept of "don't fight the Fed" in a different light, and investors are being forced to consider what their actions should be as the Fed actively takes the fight to them.
The Fed is essentially showing the private sector that although it can't make consumers consume, borrowers borrow, or lenders lend, it can unilaterally reward private capital for following its lead or punish it for not doing so -- regardless of economic fundamentals or traditional discounting models that would indicate what investors should do.
As far as I have been able to ascertain, this is a unique situation without an adequate historical comparison. I have no actionable advice to offer investors other than that they should to be aware of this situation.