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2006-08-07 :: The Fed

An article in Investors Business Daily noted that The Federal Reserve has enginered the economy so that the economic cycles are much more investor-friendly.  “Business cycles,” they wrote, “have become far more stable, with long economic expansions and short, mild recessions.”   This is the premise that former Fed Chairman Greenspan used to describe as the result of his Fed’s monetary policy activity.

This is a very investor-friendly because economic expansions translate into earnings growth, primarily for the cyclical companies whose earnings are tied to a growing economy.

With the Fed’s evolution into a body that principally uses interest rate changes to tweak monetary policy and who no longer makes changes in the money supply, we have a situation where the US economy is experiencing fairly stable growth.   As the growth starts to heat up, the Fed raises interest rates until the growth is knocked back a bit.  They have been able to guide the economy into the soft landing and avoid the deep cyclical recessions of the past by allowing the money supply to expand even as interest rates have moved up.

Our investment strategy is built around this Fed evolution, and generally avoids the “defensive” companies that sell toothpaste, sodapop and diapers.  The last time that the defensive stocks led the market was during the 2001 recession, and they led for nine months.  The 2001 recession was quite mild and barely missed the soft landing.  The cyclicals have dominated the market since then, with earnings growth benefiting from the economic expansion; the defensive stocks have been mostly flat.

This cycle, there are no current predictions that the US economy will drop into recessionary territory.  Yes, the defensive stocks that make up such a big portion of the major indices are performing better than the cyclicals at the moment.  They are up a couple of percentage points on the year and the cyclicals are flat to down a bit.  This doesn’t worry me, in fact, its part of a healthy market.

As we approach tomorrow’s Fed meeting we should see the beginning of a change in Fed interest rate policy.  They should announce that they are pausing their interest rate increases as the signs that the economy has slowed are becoming more prevalent.  Over the coming months, we will see signs that either the soft landing has been achieved or that a mild recession is in the cards (right now, the least likely scenario).   Either way, the cyclicals are poised to start leading the market once again once the economic signs are in place.

Investment returns are never a straight arrow up. There are times when strategies, like index investing, out performs active investment management.  Under the Fed’s evolution, those times will be fewer and fewer.  The smart money will pick an investment strategy based upon owning companies with growing earnings tied to a growing economy.  That’s what we’ve done and I see no reason to change that strategy unless the Fed becomes uber-bearish on the inflation prospects and severely restricts the money supply, completly changing the way that Chairman Greenspan ran the organization.  Until that happens, expect that Investors Business Daily has it correct and that the business cycle has evolved into a much more friendly place for investors.

More later!