The Bernanke Rally — October 2012

October 22, 2012

Dow Jones Average: 13,346
S&P 500 Index: 1,434


The Bernanke Rally


The Federal Reserve Board, led by Ben Bernanke, is in a battle with the forces of the free
market. Bernanke and company are trying mightily to elevate asset prices (stocks, bonds, and
real estate) and sustain the economic recovery, in the face of a debt overhang thirty years in the
making. If the free market had been allowed to follow its natural course after the debt implosion
of 2007-2008, the result would most likely have been a depression, and a major realignment of
asset ownership and control. The Federal Reserve and the government weighed in with policies
designed to prevent that outcome, and so far have managed to stabilize the economy and largely
preserve asset values. It has been a struggle, with the Fed having to employ what Bernanke calls
“nontraditional” measures every twelve months or so to prevent a reversal in the tide of the battle.

Congress has charged the Federal Reserve with a dual mandate of fostering maximum
employment in a stable price environment. An inflation rate of two percent or less per year is
widely viewed as stable prices. The Fed typically raises or lowers short-term interest rates, as
it attempts to dampen inflation, or drive economic growth and employment. By cutting interest
rates to zero in late 2008, the Fed fully deployed its primary, traditional tool for influencing the
economy. With the economy still in a rapid, downward spiral in 2009 the Fed felt that it had to
employ seldom used, nontraditional tools. In its original charter the Fed was authorized to buy
U.S. Treasury and government agency paper, which it started to do on a massive scale in 2009.
These bond-buying programs, called quantitative easing, have continued throughout the 2009-
2012 period.

In September, Chairman Bernanke announced the latest round of quantitative easing, claiming that
the strategy had been successful in supporting economic growth. He cited various studies showing
that interest rates on ten-year U.S. Treasury bonds were about 1.2 percent lower than they otherwise
would be, due to the Fed’s three trillion dollar bond buying program. We do not doubt the veracity of
the study. With the Fed in the market competing with private capital for available bonds, rates are sure
to be suppressed. Bernanke further stated that model simulations run by the Fed show a three percent
increase in overall economic output due to the lower long-term rates, which equates to two million
additional jobs created. Critics of Fed policy point out that while borrowers are saving on interest
payments, savers who invest in bonds or CD’s are losing out and have much less to spend. We can
only assume that this countervailing impact is factored into the Fed’s models.

While the redistribution of income from savers to borrowers is a debatable policy, the larger
question is whether the Fed can exit its quantitative easing strategy without causing deleterious,
economic side effects. Chairman Bernanke admits that the Fed’s experience with these new monetary
tools is limited, but he believes that they are beneficial overall and can be curtailed when conditions
change. In his speech at the Jackson Hole Symposium, Bernanke outlined the possible hazards of the
Fed’s unprecedented policy. He commented on the Fed’s dominance of the bond market, which could
obscure an accurate pricing of bonds. He went on to discuss a potential jump in inflation expectations,
and the degree to which Fed policy may be driving investors into assets (such as higher yield bonds
or dividend paying stocks) at elevated levels. Bernanke knows that overriding free market pricing is
fraught with danger, but in the end feels that avoiding a damaging, economic relapse is worth the risk.

Current Strategy

The equity markets in Europe and the U.S. staged a strong rally in the third quarter of 2012, as
Bernanke and his European counterpart, Mario Draghi, simultaneously announced another round of
central bank bond purchases. While bonds are only one of several key asset classes, the interest rate
on bonds affects every other asset class. Investors faced with historically low rates of less than two
percent on ten-year treasuries are more inclined to buy corporate bonds and dividend paying stocks.
Real estate prices are also buoyed by low interest rates as large mortgages become more affordable.
By pushing interest rates to artificially low levels, Bernanke and Draghi bolstered asset prices. The
central bank strategy is designed to improve the balance sheet of investors, which in theory should
lead to more confidence, greater consumer spending, and more jobs. The weakness in Fed policy
is that too many people fear it will need to be curtailed at some point, leaving investors with a lot of
artificially high assets that may come tumbling back down in price. To allay such fears Bernanke
recently stated that his policy would stay in effect until at least 2015.

We continue to search for investments that are reasonably priced, in an economic environment
marked by slow revenue growth. In spite of the monetary stimulus provided by the Fed, many
companies are having a hard time growing profits in a slowly improving U.S. economy. Modest
growth in the U.S. is being offset by contraction in Europe and a sharp slowdown in China. While
a handful of big companies such as Apple, IBM, Walmart, Exxon, and Merck have led the market
rally over the past eighteen months, market gains have been narrowly concentrated. The New York
Stock Exchange Composite index that includes about 1,900 companies (80% located in the U.S.,
and 20% foreign) has gained less than two percent over the past eighteen months. The relatively
tepid action in some of the broad indices, such as the NYSE Composite, means that certain stocks
may be drifting toward a buy range. We are willing to make new purchases when we find the right
combination of earnings, balance sheet strength, and a reasonable stock price.

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