Money & Finance - How We're Trading QE3

“Everything makes sense in hindsight, a fact that financial pundits exploit every evening as they offer convincing accounts of the day’s events. And we cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday. The illusion that we understand the past fosters overconfidence in our ability to predict the future.” – Daniel Kahneman from Thinking, Fast and Slow.

It would appear that the stock market has built in it, a temporary floor that is supported not by fundamentals or economics, but by sheer emotion in knowing there is a “central banking put” in place that will limit losses thus fostering above average risk-tolerance.

Earlier this week we commented on the market reaction to statements by Mario Draghi, head of the ECB. The market took as phenomenal news what we thought should be a warning. We were obviously wrong in our assessment and, while remaining in cash missed out on an aggressive rally in the stock market. Contrarianism can at times be lonely. We have decided to maintain our cash position until further digestion of this and soon to be released information.  

 

On Friday, the non-farm payroll and unemployment figures were released. The report was terrible to say the least. The labor department stated 96,000 new jobs were created last month, way short of the 125,000 that was expected. This figure has been below 100,000 in the past four of five months. The unemployment rate fell to 8.1% due to a decline in labor force participation. It was stated that 368,000 simply gave up looking for work.

If one were to include those that have dropped out of the labor force since the beginning of this anemic economic recovery, the unemployment rate would be closer to 11.2%. If one where to include  those individuals that are “under-employed” the unemployment rate jumps to 15%. Taken together, a realistic unemployment and under employment rate sits near 19%. Completely unacceptable!

 

It gets worse.

Average hourly earnings in August were $23.52, up 1.7% over the past year. With rising gasoline and food prices means declining margins for a typical family today.

The average length of those folks out of work sits at an astonishing 39 weeks, roughly 80% to 90% above the norm for this point in an economic recovery.

The U.S. labor participation rate fell to 63.5%, the lowest since Jimmy Carter was forced out of office. 

Also unprecedented is the sharp decline in the participation rate during an economic recovery. A fact that has many economists questioning whether this is a cyclical downturn or a more structural event in which American’s will need to accept a “new norm”.

Oh…and by the way, the stock market went up slightly.

 

Moral Hazard

In our opinion, this is a clear example of the floor that has been placed in the market by world central bankers.   That’s not to say the Fed is on the wrong glide path. Our view holds that Chairman Bernanke has been forced to go above and beyond traditional monetary policy stimulus measures because Washington is in such a funk. Both parties have engaged in ideological sparring and have completely rendered traditional fiscal policy measures inept.

So will the Fed ride in on a white horse and save the day by announcing additional stimulus this week in the form of a third round of quantitative easing (QE3)?

The markets certainly believe that to be the case. Many bulge bracket banks and economists have come forth to claim that, given last week’s employment picture QE3 is a done deal. Gold has rallied enthusiastically in anticipation. Reuters produced a poll of economists that put the odds at 60% that QE3 is implemented.

Given that the stock market is a dynamic sum of millions of emotions expressed in a single tick, one must assume that most of this information is reflected in the current market prices. 

We issue that statement after witnessing our behavioral model in the upper bands of optimism as it related to the market. Clearly over optimism and over confidence trumps rationality at this point.

That said, we tread lightly in what appears to be a binary market. We use binary because we have a unique instance in which we face an either/or situation. If the Fed satisfies the market, then the trend will continue to be your friend and one needs to consider stepping back into the stock market (after a miraculous run) or see the Fed disappoint and watch the start of what may be a slight market correction (one that we’d welcome).

Our strategy remains the same. After strong returns in August and for 2012, we feel it is illogical to attempt to guess which way this will ultimately play out. We remain in cash for the most part until the market dictates our next investment thesis.

- Joseph S. Kalinowski, CFA

JSK Partners of New York, LLC
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New York, NY 10005

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