Fed’s Discount Rate Announces, “Investors, Time To Get Aboard!”

Friday, February 19, 2010


On Thursday (February 18), I wrote about three trends approaching (Indicators Have Shifted – New Investment Directions in the Wind). That same afternoon’s Federal Reserve announcement of a discount rate increase is just the spark we need. For a window on what could happen, let’s look back to 1982.

During my 40-year investment management career and 46 years of investing, I have experienced many trend changes, both positive and negative. This one reminds me most of 1982. Stocks were selling at low price/earnings ratios and high dividend yields. There was general malaise among investors, with loads of advice about why it was best to own something other than US stocks.

Note: There are some obvious dissimilarities between today and 1982 – high inflation and high interest rates being the most significant. That’s why you don’t see articles comparing the two periods – rather, simplistic graph overlays are done with the 1929-1932 period. But 1982 has a very significant similarity – the Federal Reserve was keeping short-term interest rates at a very abnormal level (high). Back then, they were attempting to bring inflation and inflationary expectations down. Today’s battle has been to resurrect the financial markets, economy and confidence, waged by keeping short-term interest at a very abnormal level (low). The key is abnormality – once the Fed backs off and allows market forces to take over, new trends develop.

Importantly, these new trends are well known to us – they represent the normal functioning of the economy and capital markets. To take advantage of them we simply need to understand that we are back in normal times. Sounds easy, so where is the rub? The problem is most people cannot make a 180-degree turn in their thinking, particularly when they don’t read and hear why they should. So, “easy” applies to figuring out what to do – “hard” is taking off the pessimistic/worry face and putting on the optimistic/happy one.

Take a look at what happened in 1982, when the Fed declared victory (in their typical muted way) and allowed interest rates to start falling back to normal. (Back then, they controlled the money supply and the discount rate, allowing the federal funds rate to meander in a wide range. The more focused federal funds rate targeting began in the fall of 1982, as you can see in the graph.)

Now, let’s focus on the US stock market. Investors, as a whole, were not panicky. That had occurred in 1974. But they were not optimistic because there had been years of growing inflation, sky-high interest rates and a weak stock market (not to mention Vietnam, Watergate, OPEC’s control of oil prices and environmental problems).

But, leading investment managers were not sitting on their hands (I was running the Bank of America pension fund at the time, with a number of investment management firms). Rather, they had set up their portfolios to capture the US stock market’s return to normal. The portfolios were filled with leading companies selling at low prices – like today. The managers believed the key would be the Federal Reserve (Paul Volker was Chairman) allowing short-term interest rates to return to normal levels. It would be the signal that inflation was on the mend and better times lay ahead.

In mid-1982, the Fed did just that. Note that there was a delay before the market stock market reacted. There had been previous false starts, so the initial cut was greeted with wariness. When the third cut in the discount rate occurred within weeks of the first, and the federal funds rate got down to a “low” 10%, the US stock market took off. Within a year, it was up over 50%, not counting the juicy dividends. While there were still good gains to be made in the following years, participating in that initial performance boost made a good decade of returns into an outstanding one.

I believe we are at a comparable point right now, with the common element being the Federal Reserve’s highly abnormal rates being used to treat a significant problem. So, while our rates are near zero, the situation is the same from the standpoint that a change in Fed policy is the signal that the danger has passed and we are on the road to recovery.

Yesterday, the Fed announced that we’re there. While Ben Bernanke claims they will not be raising the Federal Funds rate soon, that sounds more like political wariness. It doesn’t really matter, anyhow, because the news coming out of the Fed (Federal Reserve bank presidents and Ben Bernanke, himself) is that the economy is no longer fragile, but is on the road to recovery. That is the signal we’ve been waiting for.

So, I believe we are at the cusp of a major bull market – not a recovery one, like last year’s, but a no-fooling, earnings growth-led expansion. The drivers that I wrote about last week (e.g., spring, levers and growth) will propel those earnings. Earnings forecasts, currently based on relatively conservative assumptions (as always happens after a recession), will end up being too low, leading to positive surprises and upward adjustments.

The second driver will be the return of both institutional and individual investors. Many (most?), like in 1982, are either sitting on their hands or are fiddling around with other types of investments, fighting the previous war on risk. The poor, maligned “average” investors (both individuals and institutions), who ALWAYS mis-time major stock market turns, ramped up selling of US stock mutual funds last week.

So, take this weekend to think about buying US stocks, if you haven’t yet, or if you are underweight compared to that allocation you set for yourself back in 2005/2006. You were right then, and returning to that allocation now is just the thing.

(Oh, and ignore any negative articles saying that higher interest rates represent “tightening” by the Fed, that stocks go down when interest rates go up, that house/car buying will fall as loan rates increase, or that company exports will be adversely affected by a stronger US dollar. All those forecasts are wrong.)

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