We Are Near The End Of This Game

Quantitative easing and policies like it are just blowing asset and debt bubbles.

The S&P 500 model is forecasting returns of 2.23%/year over the next 10 years. Even if you compare that to the 10-year Treasury Note yielding 0.66%, that’s not enough of a risk premium. We are in the 97th percentile of valuations.

Now, I know that the Fed is encouraging this. Somewhere, maybe from Bernanke, they picked up the bad meme that the Fed should care about the stock market.

Let me tell you that that way lies madness. The Fed is banging hard on the “voting machine” aspect of the stock market, while the “weighing machine” quietly looks on saying, “You’re going to pay for this.”

Let me put it bluntly: Quantitative easing and policies like it are just blowing asset and debt bubbles. Can the Fed create conditions that lever up the economy, and create prosperity in the asset markets? Yes, but only for a time. Eventually, the markets begin to look through the actions of the Fed and the US Treasury and conclude that the emperor has no clothes. Gold is the silent witness in these matters, as is the value of the US Dollar to a lesser extent.

The Fed should only care about the solvency of the financial system, and act to avoid bubbles. Forget inflation, forget employment forget real GDP growth. In an open macroeconomy where there is a lot of technological change, the Fed can’t affect any of those much. If you are going to have a central bank, it should focus on avoiding financial crises.

And since Greenspan, the Fed has done the opposite of that. Instead of letting recessions liquidate bad debts, the Fed has “rescued” bad corporate and household decisions, by lower rates continually. Well, now we are near the end of this game, and current interest rates and likely future returns are lower than any other time than the dot-com bubble.

For investors, there are a few choices. Go low debt in stock selection, and look at small stocks, value stocks. and international stocks. All offer more future returns than the current FANGMAN consensus of largest-cap growth. Also, even though bond yields are low, short duration high quality bonds will lose a lot less in a panic than other assets.

That is what I am doing. You can do what you want, but this i a time to pay more attention to preserving capital, because even under the best conditions, you aren’t going to earn much in large cap US stocks over the next 10 years.

About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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