The Bernanke Guarantee — July 2013

July 24, 2013

Dow Jones Average: 15,542
S&P 500 Index: 1,686


The Bernanke Guarantee


Over the past few years the stock and bond markets have become increasingly dependent on
money printing from the Federal Reserve and other central banks. The Fed has pumped trillions
of dollars into the financial system by buying treasury and mortgage securities. So when Fed
Chairman Ben Bernanke hinted on May 21st that the U.S. central bank might taper its pace of
bond buying this fall, and end the program in 2014, investors became extremely anxious.

The Fed has been supporting the economy and the financial markets just as a protective
parent places a hand under a child learning to swim. While the economy was barely kicking
back in 2009, it is now showing more strength. Still no one seems to know whether the
economy and the markets will sink or swim should the Fed remove its supportive hand.
Bernanke’s constant reassurances of aid from the Fed have made investors more apprehensive
about an eventual change in policy. By disguising free-market signals, Bernanke has fostered
an economy that is tentative and fragile. The slightest indication that he is even thinking of
someday removing the unprecedented level of support sends investors into a state of panic.
The immediate, negative reaction in the financial markets, following his comments on May
21st, pushed Bernanke to further explain, modify, and all but retract those statements. Things
have since returned to the status quo, with the economy and the markets kicking along
supported by Ben’s firm hand.

Bernanke faces a tough choice, as the markets demand a continuation of policies that
he knows must end at some point. If governments could simply print vast amounts of money
year after year, without causing rampant inflation and financial bubbles, it would be standard
policy. But such policies do cause inflation, financial bubbles, and the misallocation of capital
over time. A surplus of capital leads to careless, ill-considered investment decisions. To avoid
a repeat of the financial bubble and bust pattern so endemic during the Greenspan years, Ben
Bernanke tried to float the possibility of slowly withdrawing the Fed’s capital infusions. The
market reaction was so quick and violent that he backed down, implying that for now he will
continue to support and virtually guarantee current asset prices. We expect that this guarantee
has a time limit, and that some day investors will have to swim on their own.

Current Strategy

It is extremely difficult to get a true reading on the strength of the economy or the markets
when the Fed has overridden most free-market forces. The Fed has set short-term rates at
zero, and has been suppressing intermediate and longer-term rates by crowding out private
bond investors. While this multi-year policy has finally spurred home and auto sales, it has
punished savers and pushed investors into decisions they might not otherwise make. Our
stock evaluation scale indicates that most stocks are fully priced or over-valued. We think that
stocks should be selling at a discount to the norm, not a premium, given a tenuous economy
that is so dependent on government support. Current stock prices provide investors with little
downside protection.

As is the case with most investors, we are holding some stocks that are fully valued,
pay decent dividends, and will most likely stay high as long as the Bernanke guarantee holds.
The short-term bonds and cash we hold in accounts are the buffer to these stock holdings.
When it comes to additional purchases we are looking for situations where something unusual
is happening at a company. A major upgrade in products, or expansion of a new business line,
can trump macroeconomic trends or a shift in interest rates.

Interest rates on ten-year treasury notes have risen in recent weeks to the highest level
in about two years. Investors do not know where rates will settle when the Fed stops buying
so much of the existing and newly issued bond supply, but it is likely that the rate will be
higher than the one to two percent yields of recent years. The fifty percent jump in rates
between April and June indicates that private investors will demand a far greater rate of return
than the Fed. We were pleased that our fixed income positions held up relatively well during
the bond rout. If rates approach three percent on ten-year paper, we are prepared to modestly
increase holdings of fixed income assets.

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