Posts filed under “Philosophy”

Fed is Too Focused on Wealth Effect, Equity Markets

 

“When will these guys ever learn that maybe, just maybe, these Fed policies aimed at targeting asset prices at levels above their intrinsic values is probably not in the best interests of the nation?”

-Dave Rosenberg, chief economist and strategist at Gluskin, Sheff

 

Not long ago, I was listening to former Federal Reserve Chairman Ben Bernanke discuss the central bank’s actions during and after the financial crisis. I came away very impressed with how thoughtful and intelligent the former head of Princeton’s economics department was. Combining a deep academic background in the Great Depression with outside-the-box thinking made him the perfect person to lead the Fed during this period.

There was one issue in particular that bothered me about his tenure, and it isn’t a minor one. It is the Federal Open Market Committee’s focus on the so-called wealth effect, and its corollary impact, the stock’s reaction to Fed policy.

Let’s begin with a quick definition: The wealth effect is an economic theory that posits rising asset prices leads to beneficial effects in consumer sentiment, retail spending, along with corporate capital expenditure and hiring. It is based on a belief in a virtuous cycle that begins with equity prices. As they rise, investors and senior corporate managers begin to feel more secure and comfortable in their financial circumstances. This improvement in psychology releases the “animal spirits,” along with a commensurate increase in spending. Pretty soon thereafter, the entire economy is moving on the right direction.

But Fed policy makers seem to have gotten this precisely backward. Their premise is based upon a flawed statistical error, one that confuses correlation with causation. Building an entire thesis upon a flaw is likely to lead to poor results.

Why is the wealth effect a flawed theory?

Start with that correlation error: What actually occurs during periods where stock prices are rising? As Benjamin Graham observed, over the long term, markets act like a weighing machine — valuing equities based on their cash flow and earnings. During periods of economic expansions, it is the rising fundamental economic activity that reflects the positive things wrongly attributed to the wealth effect. Companies can hire more and increase their capital spending. Competition for labor leads to rising wages. Employed, well-paid workers spend those wages on capital goods such as cars and houses, and discretionary items like entertainment and travel.

Oh, and along with all of these economic positives, the stock market is buoyed as well, by increasing profits and more buoyant psychology.

In other words, all of the same forces that drive a healthy economy, leading to happy consumers spending their plump paychecks, also drive equity markets higher. The Fed, though, seems to think that the stock-market tail is wagging the fundamental economic dog.

As we saw in the mid-2000s, it wasn’t the wealth effect driven by rising home prices that led to greater economic activity, but rather access to cheap and widely available credit.

The flaw in this thesis is even more obvious when we consider the distribution of equity ownership in the U.S. The vast majority of employees and consumers have only modest investments in equities. When we look at 401(k)s, IRAs and other investment accounts, we see these are primarily held by the well-off. Ownership of equities is heavily concentrated in the hands of the wealthiest Americans. Start with the top 1 percent: They own about 40 percent of stocks (by value) in the U.S. The next 19 percent owns about 50 percent. That leaves the remaining four-fifths of American families holding less than a 10 percent stake in the stock market.

With so few people actually invested in the results of the stock market, how can it have such a broad effect on consumer spending? It doesn’t, unless the Fed wants to make the case that it is driven primarily by the trickle-down effect. I doubt they would want to do so for obvious political reasons.

Which leads to a Fed policy that has become overly concerned with the markets reaction to well, everything. Fed policy, FOMC member speeches, even FOMC minutes are obsessively considered in light of how markets will react to them. This is a terrible and unique Fed error. It makes for bad policy and worse governance in a democracy.

Some might perceive the wealth effect and the focus on market reactions to be two distinct issues. In reality, they are so closely intertwined that they are effectively two sides of the same coin.

The Fed must put to rest this flawed approach, and along with it a wealth of poor policy decisions.

Originally published here

Category: Federal Reserve, Philosophy, Really, really bad calls, UnGuru

54% of Republicans Say We’ve Got Too Much Inequality

It’s a Myth that Conservatives Don’t Care About Inequality We’ve noted for years that it’s a myth that conservatives accept runaway inequality. Conservatives are very concerned about the stunning collapse of upward mobility. A poll from Gallup shows that a majority of Republicans think we’ve got too much inequality: Two out of three Americans are…Read More

Category: Philosophy, Politics, Wages & Income

Look Out Below, Follow Through Edition

click for updated futures     Yesterday, we discussed the likelihood of an equity correction versus the end of the bull market. Today, futures are deep in the red, looking like another 1 percent sell-off or worse awaits us. European stocks are down 1 percent or more, with the IBEX off more than 2 percent….Read More

Category: Markets, Philosophy

Assets versus Prices

Josh has an excellent post up, titled Don’t Hate the Asset, Hate the Price, that makes several important points. I want to reiterate and expand on them here. Some of these are lynchpins of an investing philosophy I have been espousing for many years. Its a broad discussion on price and value, and I think…Read More

Category: Investing, Philosophy, Really, really bad calls, Valuation

Neil deGrasse Tyson on Science, Religion and the Universe

Category: Philosophy, Science, Weekend

NoahOpinion’s Heroes of Blogging

Lovely sentiments from Noah Smith on a few of your favorite bloggers, including Josh Brown and yours truly: Barry Ritholtz: There is a huge amount of financial disinformation and misinformation and just plain bullshit out there in the world. Most financial news is random noise, and some is even worse than that. And there’s a…Read More

Category: Philosophy, Weblogs

Understanding Time: A Long Term Perspective

click for ginormous version
Perspective on Time
Source: Mayra Artes via Visual.ly

 

A different and perhaps more easily readable version of this is here . . .

 

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Category: Digital Media, Philosophy

The Art of Intuition and the Science of Discovery

“The intuitive mind is a sacred gift and the rational mind is a faithful servant. We have created a society that honors the servant and has forgotten the gift.” ~ Albert Einstein What is intuition and how might it help or hinder an investor’s decision making process? A good philosopher begins with definitions, otherwise they…Read More

Category: Philosophy, Psychology, Trading

The Clever Fighter

Over at Forbes, Jessica Hagy (of Indexed fame) has been illustrating the Art of War, with excellent results. This observation from Ch4 tickled me: “What the ancients called a clever fighter is one who not only wins, but excels in winning with ease.”   Jessica Hagy via Forbes

Category: Digital Media, Philosophy

Putting Time In Perspective

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Category: Digital Media, Philosophy