October 2012 Investor Letter
A lot changed in September.
The S&P 500 finished up 2.5% for the month and up 5.5% for the quarter, but if you blinked you may have missed most of the gain because almost all of it happened on two days. On September 6th and September 13th the index rose by a combined 52 points or about 3.7%. Counting that and the 33 point gain that happened on the last day of June, 85 out of the 193 points that we have rallied from the June lows have come on three trading days.
Each of those three days had an important commonality: central bankers drove the market. Back in June, the market rallied when Mario Draghi hinted that the ECB might be working on a new plan to save the Eurozone. On September 6th he rekindled that hope with a pledge to buy an unlimited amount of sovereign bonds if things got worse. Then on September 14th Ben Bernanke outdid him by not just threatening but committing to open ended bond purchases.
This most recent round of easing represents the most radical Fed move yet because it takes money printing from a finite proposition to an infinite one. The Fed has said that it won’t stop printing money until the economy is well into recovery, and has thus given everything it has left to try to stimulate near term economic activity. If this fails the only option remaining is to print even more rapidly or perhaps buy riskier securities.
If the economy reaches Bernanke’s goals, it will likely be in spite of QE3, not because of it. At its most fundamental level, the point of QE is to manage market psychology and awaken Keynes’ “animal spirits.” Bernanke is certainly changing market psychology, but I’m not sure that he is doing so for the better. I have yet to hear a CEO say that he or she is more likely to hire another worker because the Fed has pumped another trillion dollars into the economy. Unfortunately there is zero empirical evidence that money printing can lead to real economic growth. On the other hand, there is plenty of empirical historical evidence that it can lead to inflation.
QE3 creates more inflation risk than either of its predecessors because the economy is not nearly as impaired as it once was. We are no longer in the juicy part of the cycle when economic indicators can slingshot higher as the economy moves from a low level of capacity utilization to a high level. The “V” has occurred, and now earnings are beginning to flat-line. This doesn’t mean that they have to go down, but it does mean that the economy is reaching its potential output. High capacity utilization plus stimulus leads to CPI inflation.
For our portfolios this means that we will be making some significant adjustments before the year is done. In the near term, I continue to expect a market pullback on the realization that earnings growth is slowing, but in the long term, cash is quickly losing its status as a safe harbor, and we hold too much of it. Counter-intuitively, equities are becoming one of the safest assets to hold because earnings will eventually grow with inflation. However, most investors continue to pull money out of equities, which could create the right circumstances for a blast higher if individuals ever felt the need to get back into the market, like if rates started to finally move higher…
Scott Krisiloff, CFA