June 21, 2013
Well, now you know.
Investors love it when the Federal Reserve is throwing easy money into the system. They follow an old Wall Street adage: "Don't fight the Fed."
In other words, when the money is flowing from the Fed, you put it to work buying risky investments — stocks, high-yield bonds, commodities, and stocks and bonds from risky corners of the globe known as emerging markets.
Then, as the herd propels all those risky investments higher, you feel good and tell yourself that the globe must be gathering economic strength after all. You see the soaring stock market as proof. So you buy some more, along with the investing herd, and as a group you create an enticing narrative that sizable growth is coming and stocks should go higher.
But now the rules of "Don't fight the Fed" are being played out in reverse. The Fed is starting to talk about pulling away on some stimulus — so not fighting the Fed means to grab your money and run. That's exactly what investors have been doing the last two days as the Dow Jones industrial average has plunged about 560 points, 354 on Thursday.
The extreme reaction has shocked some, and unleashed fear.
"The markets are having convulsions," said Jim Bianco, president of Bianco Research.
Investors are wondering now if the delightful 23 percent gain in the stock market since November simply came from the old game of not fighting the Fed, or whether there were legitimate economic reasons for stocks to surge to records repeatedly.
If there's been more at work than just the knee-jerk stock-buying that comes when the Fed is pumping easy money into the system, what are the legitimate fundamentals? Based on fundamentals like growth in the economy and likely corporate profits, where should stock and bond prices really be?
Investment pros have been debating the topic for months. Some, such as Pimco bond king Bill Gross, have asserted that there's been so much tinkering by the Fed and other central banks in the world that stocks and bonds both moved to artificial prices based on artificial economic fundamentals.
In other words, with trillions of dollars pouring into the markets from the Federal Reserve and other central banks around the world, no one could determine what a fair price should be. Some even wondered if they could judge the strength of the economy or corporate profits at all, given all the easy money sloshing around the world.
On Wednesday and Thursday, the 560-point plunge in the Dow seemed to say that investors had decided they had at least overpaid 5 percent for stocks. Or maybe professional investors simply thought the situation was so murky, they didn't want to stick around to find out.
It's a lot easier to be the first investor to bolt rather than waiting for the masses to do the same. The pros know that once they have secured their cash, they can always take their time trying to figure out where the economy and corporate profits might go. And then they can invest again if they see a good price and decide the reaction of the market has been too panicky.
Convulsions are hard to read in the stock market during this era of high-speed trading, when computers react to momentary spasms and can turn them into uncontrollable convulsions. But the way Bianco sees it, investors decided this week that the long period of massive stimulus was coming to an end and decided not to wait for the months of tinkering by the Federal Reserve to follow. Rather, he thinks investors are recalculating what stocks and bonds should be worth without stimulus, and are responding now as though the economy and the markets have already gone cold turkey on low interest rates.
The first test for fundaments might arrive in a few weeks as companies report second-quarter profits. But since Federal Reserve Chairman Ben Bernanke said the Fed will keep some stimulus going into 2015, playing "Don't fight the Fed" could be filled with twists and turns for a long time yet.
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