In the Fed We Trust?

September 18, 2012

Should investors be imprinted with "in the Fed we trust"? Perhaps not.

-David W. James, senior vice president, James Investment Research
-Matt Watson, James Investment Research

Stock Market Analysis

Stocks enjoyed a solid week. Large stocks advanced 2% and smaller issues gained 2.7%. Breadth was favorable as well with nearly twice as many stocks advancing as declining.

The week was trumped by expectations of QE3 by the Federal Reserve. Stock and commodity investors were not disappointed. Printing lots of fiat money historically has helped equities in the short term but the economic benefits are questionable.

We may be seeing a case of "buying on the rumor." Will they sell on the fact? Thompson Reuters highlights that since 1994 most of the gains in stocks occurred in the 24 hours prior to the Federal Reserve meetings.

So, should investors be imprinted with "in the Fed we trust"? Perhaps not. Reuters has noted the exceptionally poor track record the Federal Reserve has regarding economic projections. Thus the wise investor should take pause in considering the recent upgrades in GDP forecast by the Fed.

There has been some encouraging news. Retail sales were up strongly in August. Much of the gains came from higher prices at the pump; a dubious honor on the sales figures. Big ticket items such as vehicles and building materials gained over 1% in the month.

We are concerned about the market's read on valuations. Value investing often looks for companies whose stock prices are cheap relative to their earnings or book value. Long term this style of investing has a high degree of success. Lately, this has not been the case. Investor attitudes towards value range from apathetic to belligerent.

Our research examined the cheapest and costliest stocks according to popular measures such as P/E, P/Cash, P/Sales and P/Book. So far in 2012, the cheapest stocks, as a group, lost money while their costlier cousins have enjoyed gains.

We also note the earning pressures some companies may feel in the upcoming months. One way of gauging this is the inflation premium where we compare the inflation levels on the retail (CPI) and wholesale (PPI) levels. When retail inflation is running hotter it suggests companies can pass along all of their cost increases plus a little extra to their customers. However, for the first time since March the rolls reversed. Historically this is bad news for profits and stock prices.

Presently our leading indicators have improved off of their worst levels but have yet to give us an all clear signal. A neutral approach is advisable until the elevated risk levels subside.