Don't Fight The Fed

What exactly does the expression don't fight the Fed mean? The Fed wants to drive asset prices higher (stocks, housing, & commercial real estate). The Fed can create money out of thin air, which is a very powerful tool. Fighting the Fed speaks to fighting the Federal Reserve's goal of creating higher asset prices. For those new to the Fed fold, money printing, quantitative easing (QE), and bond buying programs all speak to basically the same thing - monetary stimulus from central banks.

Are Interest Rates The Problem?

If we are to make the best decisions possible with our investment capital, it is imperative we understand why the Fed prints money and how it helps them (in theory) meet their dual mandate of low inflation and maximum employment. Central banks like to talk about bond buying programs in this manner:

Therefore, central bankers like to justify money printing as a means to create lower interest rates. Rates have been near record lows for several years. It is not logical to assume a large corporation is saying, "Boy, we have a business need to build a new factory, but interest rates have just been too high." The point is rates are low and rates have been low. Therefore, the Fed must be printing money for other reasons.

Fed's QE Acts As Kindling

The second goal of money printing is to recreate the wealth effect, which is outlined in the flow chart below:

Fed Trying To Pass Stimulative Torch

The hoped for end game with printing money to create the wealth effect is to allow the Fed to eventually pass the economic torch to private investment and the broader economy.

Profits Bring More Capital

If an investor's 401(k) balance is growing, they are much more apt to take additional cash off the sidelines and invest it, which is exactly what the Fed wants. There is some recent anecdotal evidence to support the print-push demand game plan is working for the Fed. From ETF Trends:

"If you are looking for the source waters of the recent melt-up in U.S. stock markets, look no further than U.S. listed exchange traded funds," says Nicholas Colas, chief market strategist at ConvergEx Group. "Over the first 12 trading days of the new quarter, investors have added some $24.4 billion of new assets to ETFs which focus on U.S. equities, or over $2 billion per day," he said in a note Friday. "That's almost 4x the run rate of the first half of 2013 and simply a torrent of fresh money by even the ETF industry's go-go standards."

Mutual Funds Create Tremendous Buying Power

Many traders and active money managers use ETFs today rather than mutual funds, which means they tend to forget the still enormous demand for stocks created by fund managers. As of the end of 2012, mutual funds still controlled nearly 10 times more assets than ETFs.

The vast majority of stock mutual funds stay very close to fully invested at all times. Why? From a liability perspective, if they carry large cash positions and underperform the market, an investor can say, "Hey, you said this is a growth fund, why did I miss the rally?". Attorneys do not like questions like that. When an investor sends new money to a stock mutual fund, the fund's manager tends to invest it in short order whether they like the current market or not. Investors making regular 401(k) contributions also create tremendous demand for stocks via mutual funds.

Fed's Stance Makes It Difficult

Over the past few years, the Fed figured out that markets went up before and during a round of money printing and markets went down as the program was ready to wind down. Their solution was open-ended and economic-dependent money printing. At this point, investors do not know if they should prepare for imminent tapering or a surprise announcement in September of "no changes".

Investment Implications

Over the next few sessions, one way to wade through the uncertain waters is by picking "leave it alone" levels on the S&P. As long as the S&P 500 can hold the recent breakout above the May weekly closing high of 1667, then our bias will be to hold our long positions in the market (SPY), and leading sectors (XLF). If the recent breakout is retested, 1667 is important from a weekly perspective.

If you only have access to daily charts, the level to watch is 1669 on the S&P 500. This means the bulls can have some "give back" over the next few sessions without creating high levels of anxiety.

Concerns Call For Flexibility

Our market model and portfolios remain in a bullish stance. However, we do have some concerns. The Fed still appears to be on track for a tapering announcement in September. The market-leading sectors we own, such as financials (XLF), technology (QQQ), and small-caps (IWM), have very little company. We would feel better if this rally began to broaden out via some improved relative strength (vs. SPY) in emerging markets (EEM), foreign stocks (EFA), and materials (XLB). If you want to learn more about how QE works in the real world, this popular video is a good place to start.