Fed-Watching: Meager Actionable Insight

In this episode, Clem Miller and Steve Davenport address a key investor question:  Just how actionable is the economists’ and strategists’ standard playbook of intense “Fed Watching”?  

Steve and Clem challenge the myopic view, reinforced by business media, that somehow the Fed  is an all-seeing puppeteer controlling U.S. and global financial markets.  

Steve and Clem point out that for investors to make any money on Fed decisions depends on their being able to make quick macro trades on non-consensus views on inflation rates and employment.   And even then, the chances of success are minimal. 

Steve and Clem stress that they favor buy-and-hold investing, where earnings, corporate structures, and capital allocation, among other fundamentals sculpt stock performance, outweighing the influence  of the Fed’s short-term interest rate adjustments.

Straight Talk for All - Nonsense for None


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Chapters

• 0:27 Relevance of Fed Watching in Investing
• 18:12 Fed Influence on Stock Market Overstated
• 27:00 Focus on What We Don't Do

Transcript

Steve Davenport: 0:27

Hello, this is Steve Davenport from Skeptic's Guide to Investing. I'm here today with Colin Miller.

Steve Davenport: 0:32

And we're going to try to talk about. What is the major media event for the last six to nine months, which is Fed watching and the Fed and their decision about when they will possibly lower rates. There seems like a lot of other things to think about with Ukraine, gaza, the overall intensity of inflation in various areas, real estate, interest rates but we in the media are looking at this and saying should we really be focused on the Fed? Is the focus on the Fed misguided? What is their real purpose and how do we use that as a form of alpha for our strategies? Can you add alpha from this idea of looking at the Fed? If it were true, then everybody's Fed watcher would be the highest paid person with the hedge funds. I'm not sure that's the case.

Steve Davenport: 1:36

I think that when we look at this and I want to ask Glenn, because he's much more of a fundamentalist in terms of how the companies react I look at this and I say the Fed is trying to use one measure interest rates as a way to influence the economy. And when we think about the US economy, we think about Texas and the oil regions and Oklahoma and other areas. We think of technology in Silicon Valley and up in the great Northwest near Seattle, and then we look at auto production in middle America and we look at the financial sector in New York. Each one of these areas or Fed districts is going to have a very different view of how interest rates affect us. If we have an area that's growth is coming mostly from housing aka Florida, north Carolina, south Carolina those areas should have a much bigger influence in terms of how interest rates affect them. Other areas, like the technology areas in California, they're not using debt. Therefore, if they're not using debt, does the rate matter? Does the rate matter for Microsoft? Does the rate matter for Oracle?

Steve Davenport: 3:01

Is it about AI and nothing about interest rates? If it is, then you could take whole sectors of the economy and just move them away from this discussion. And if you think about where's the growth in the economy, why would we focus on interest rates when we can focus on growth rates of 20% or 30%? Because of new insights into how AI will evolve over the next five 10 years insights into how AI will evolve over the next five 10 years. It's a much nicer discussion because it has a much better result. An extra 50 basis points may mean something bad for a lot of the commercial real estate holdings of mid-sized banks, but it doesn't mean anything to the technology sector. But it doesn't mean anything to the technology sector, clem, when you look at the Fed and I'll just say A or B, relevant, irrelevant.

Clem Miller: 3:59

I would say mostly irrelevant because and I would use a somewhat different word, I would use the word actionable from an investment standpoint Is all this Fed watching really actionable? And I would say that it is not actionable, and I would give a few reasons for saying that. You've touched on a few of them, which is that the economy is really too broad for the Fed to act. I would say that if you look at what some of the media, the business media, talk about with regard to the Fed, you would think that the US is a centrally planned economy, like the Soviet Union used to be, that the Fed is pulling the strings as if the economy was some kind of marionette. And it's really not. The economy has a life of its own and, if anything, the Fed is really riding this bucking bronco that it really can't control. And so I would say that you know that. You know really, it's hard to be able to look at the Fed and say that you know they're doing, that. You know they are the ones that are in control of the economy, because they certainly are not in charge of the economy.

Clem Miller: 5:27

Now, I would also say that there's a certain amount of expectations theory that's involved in looking at the Fed.

Clem Miller: 5:37

So it's not a question really of trying to determine what the Fed is going to do, which is really the content of a lot of media and personalities, economists, who talk about this. It's really the more important thing is discussion of whether the expectations regarding the Fed and Fed actions are actionable, and there you've got so many folks from all the investment firms that have economists, chief economists and whatnot who are looking at the Fed. You've got so many folks looking at this that there's a consensus opinion that arises and you know you could only really make. You know, assuming if you assume that the Fed was in control of the economy, you know you'd only be able to make money if you had a non-consensus opinion that was actually correct. And the tendency of many economists is to not move away or not challenge the overall consensus. They get paid to make decisions and they're never going to get their pay docked if they make a decision that everybody else is making or offering an opinion.

Steve Davenport: 7:12

They all get it wrong.

Clem Miller: 7:14

What.

Steve Davenport: 7:15

Or if they all get it wrong.

Clem Miller: 7:16

Or if they all get it wrong, if they all get it wrong, they're still not going to get docked because everybody else got it wrong too. So yeah, I think, given that this is about that, the only way to make money is to have a non-consensus opinion. That's correct. I think that the opinions and the analysis of the Fed is really not all that actionable compared to looking at other things that are affecting the economy, and by that it's not just the US economy we're talking. The global economy is important too, since some 40 percent of S&P 500 revenues come from abroad. Us economy is the global economy is important as well. So I, you know those whether the fed is relevant or not, is I think it's. I think it's much less relevant than many people actually think it is.

Steve Davenport: 8:17

People started to think about this and when I looked at um, I'm a big believer in the uh research that talks about the wisdom of crowds, right, and research that talks about the wisdom of crowds. And when you think about the wisdom of crowds, these people gravitate towards something. And we're going to talk about meme stocks later in another podcast. But when you see people moving in a certain way and you see a lot of attention given to the spend, you would suspect I wouldn't give something this much attention unless there was this much benefit. Right, I mean, economic animals were driven to. We've got eight hours in a day that the market's open and we look at it and say, okay, how do I use those eight hours to help my clients generate better risk-adjusted returns and move on in terms of capturing growth and extracting value?

Steve Davenport: 9:17

But I just am amazed,Clem, why is there such hope? If you and I are right and that it is mostly irrelevant? If you and I are right and that it is mostly irrelevant, which I believe is the right decision how does it become such a fervor and such an intense speculation about this event or potential event when we say, gee, if it were inefficient to do this, people wouldn't waste their time, but yet we say over and over and over again that they do waste their time. So I guess I'm having trouble with the economic animals and CNBC and how they are looking out for the average investor out there watching TV. Out for the average investor out there watching TV. Maybe the average investor isn't watching TV. Maybe the average investor is sitting there and saying I never watch CNBC because it hypes up too many things and it gets too involved. Maybe I mean, is it possible that we're, as an industry, we've given people a lot more credibility than they should have, or given them a lot more power to talk about a topic that maybe it isn't relevant.

Steve Davenport: 10:54

Maybe it is relevant we're just not educated enough to appreciate the subtleties.

Clem Miller: 11:03

Yeah, I think that, like I said, like you've said, I think that investors put way too much emphasis on what the Fed may or may not do. There's a big focus on everybody knows that when the Fed acts, they act on the basis of what's going on with inflation and also with employment statistics, and those are not really all that predictable. And so you could have one week you could have inflation go down the next month. One month you could have inflation go down. The next month you could have inflation go up. One week you could have unemployment go down. The next week you could have unemployment go up.

Clem Miller: 11:51

And it's sort of basically jerking around investors. It's noise. You know a lot of investors are looking at that and make, trying to make decisions based on this noise. And you know what, steve? They are playing into the hands of speculators. It's the speculators who are making money off those who off those who just don't know that they should focus on fundamentals of individual stocks and especially those.

Clem Miller: 12:36

It's much better to sort of hold on to positions, buy and hold, than it is to buy and sell all the time based on you know to do. You know a lot of trading, you know like I'm talking about, you know, moving to cash, moving out of cash, moving into cash, moving out of cash, based on whatever's happening with inflation and employment in a particular week or month. It's just, it's, it's sort of crazy how much people look at this one institution and make decisions based on what this one institution is doing. I mean, it's, it's like, you know, it's like the movie, right, wizard of Oz. The Fed is not, is not Oz, the Fed is not Oz.

Clem Miller: 13:25

Or let's put it this way the Fed is Oz, has no A little taller than Oz, but it's not completely different than Oz. In fact, I kind of believe, if I remember correctly, that the Wizard of Oz was kind of an analogy for the Fed. If you look back, there are a lot of analogies in that movie. I think the Wizard of Oz was an analogy for the Fed. If you look back, there are a lot of analogies in that movie and I think the Wizard of Oz was an analogy for the Fed, and I think there was some wisdom to that back in the 30s, and now we're about 90 years away from that and I think it's still appropriate, I agree.

Steve Davenport: 14:00

I think the other aspect of this and I know that you'll have a little trouble with this word, but it could be to me that there's politics involved here, clem to make the right decision and yet they tell people it's highly favorable for us to not do any increases or decreases around the election, because then we'll be viewed as political and they'll be politically motivated and I sit there and I go. Isn't the whole world political? Yeah, I have most decisions having an influence of somewhat from politics.

Clem Miller: 14:45

Absolutely and to not make this idealist view of the Fed.

Steve Davenport: 14:51

Like they are. They take the information and they bring it to the mountaintop and everybody comes to the table, and at the table, all ideas are shared. Ideas are shared and there is general looking for consensus and looking for a better ideal of how the economy should operate. It feels to me a little bit like how do we come and tell ourselves these stories that make us believe that, yes, these people are so wise and so good that they will not make decisions, even if the data is saying just so? They avoid the outcome of looking political.

Steve Davenport: 15:34

Does that make sense. I mean, if the rates come down, they should come down in February, they should come down in September, it shouldn't be. Oh wait a minute, we're this many days away from the election and therefore we can't lower rates, because that would just look too political right.

Clem Miller: 15:54

Well, yeah, I mean, and a decision not to do that is itself political. So no matter which way they go, it's a political decision.

Steve Davenport: 16:05

Either way. Yeah, I just think that trying to you know, why don't we simplify according to our two variants? We are making this decision based on how we see the price, of price control. We are making this decision based on what we see from employment. We have this third rail or third variable, which is how is the market doing? Because if the Fed really looks at itself and says how many decisions has it made in the last 10 years, tell me how many of them have been based on a reaction to the market being too high, too low or suddenly not working the way it was supposed to work, I would say that it's probably in that 70% 80% of the decisions are based on the market of securities, which are only owned by half of the economy. So if the population doesn't all own stocks, does the Fed really need to be focused on how stocks are reacting, or is it really the underlying economy? Are stocks the underlying economy, clem?

Clem Miller: 17:23

Oh, of course not. But from an investor standpoint, you can't invest in the economy, you can't invest in GDP, you just can't right. There's no instruments for doing that. You can invest in stocks, and stocks don't represent shares of the economy. They're more than that. They represent earnings growth, which is based on US and basically global economic growth based on shares which can be bought, which can be repurchased, dividend yield, multiple expansion, which is partly based on rates but also partly based on things like geopolitical risk in terms of spreads.

Clem Miller: 18:13

There's a lot that goes into share prices that go way beyond just Fed control of interest rates. In fact, the Fed can't even control long-term yields. Long-term treasury yields. Long-term treasury yields whip around regardless of what happens with the Fed on the short run. They don't control even the whole yield curve. I mean, unlike in Japan which until recently, was trying to control the whole yield curve, the US doesn't do that, the Fed doesn't do that and, if anything, the longer end of the yield curve, 10-year treasury yields that's way more important for stocks than what happens on the short end with the Fed funds rate.

Steve Davenport: 19:05

Well, I understand companies borrowing and companies need access to capital, but again, isn't that industry specific? It's not really all companies. A lot of companies, small companies are funded by internal cash flow, so they don't need to know what the rates are. They just need to know how their business is going. And if real estate seems to be the one that I think has just been crazy recently is these higher rates were going to cause a downturn in real estate and it hasn't happened.

Clem Miller: 19:39

Yeah, I mean this little supply. I mean real estate is a great example. The whole stock market, I should say, has been doing quite well, despite the fact that rates continue to remain high. So coming back to is the Fed providing us actionable information? If you just based your stock market decisions on how high the Fed funds rate is, you would have lost out on a whole bunch of stock market appreciation over the last couple of years. I mean you would have been, you'd be looking at all. If you based it all on the Fed, you'd be looking back and saying, gosh, I missed out on all of this stock market appreciation. You'd feel terrible and I'm sure some of you may have done that and are looking back and saying, darn, I shouldn't have done that.

Steve Davenport: 20:35

Well, I think that, first of all, I think it simplifies the story. If you're in the media or at CNBC and you say people want a simple story, they want to understand higher rates mean bad for the economy, bad for stocks, lower rates good for stocks, good for the economy, good for spending, and I would love for the world to operate in simple if-then. But I've come from the belief that we all have multiple variables. It's a multivariate approach. There's four or five areas earnings, earnings growth, overall corporate structure, capital allocation decisions. There's many things that we need to put into the equation and the Fed's influence on interest rates is one of those variables and I guess do you have. If I said, the economy and the stock market is going to be based on these four variables and how I believe that I'm bullish or not is going to be. If all of these things are clicking, these are going to be the things that help us to achieve better results. What would be your top four?

Clem Miller: 22:01

Well, I take a look at this from a stock perspective. You mentioned capital allocation. Capital allocation that's something that is a management decision, company by company by company, which you can see based on where the free cash flow is being allocated. So some of those, a lot of that, is based on individual company decisions. But if you aggregate it, if you look at this on an aggregated basis, which I think is the you know sort of where you were going, Steve, with the question.

Clem Miller: 22:33

I think taking a look at dividend policy, dividend growth, dividend outlays as a percentage of free cash flow or earnings, I think that's a key element. Free cash flow or earnings, I think that's a key element. Dividends, stock buybacks the higher the stock buybacks, I think the better. Overall revenue growth in the economy or overall sorry, overall revenue growth of S&P 500 stocks, I think is relevant, and, of course, S&P 500 stocks, I think is relevant, and of course, that's a function of the US and global economy. Profit margins right, Because profit margins are what convert revenue growth into profit growth and, as I pointed out, share buybacks convert profits into earnings growth. And then, of course, multiple expansion right, so that's relevant as well. So all of those things are important. They're important at the aggregated level and even much more important at the individual stock level.

Steve Davenport: 23:41

My point was going to be if we came up with four or five variables, I think it would be hard, I think it would probably be more like six. And then you'd say how do I make one of these variables worth a lot more than the others? Then you'd say I probably would just equal weight them, just because I don't have a definitive way to isolate the variables. Then I'd go okay if there's six and there's 16% each in terms of impact on the underlying. The Fed is one of six variables. It's not-.

Clem Miller: 24:17

MIKE GREEN. I wouldn't even, personally, I wouldn't even put them in the six.

Steve Davenport: 24:21

MIKE GREEN. I think interest rates and its impact on consumer spending, all the things that flow from the Fed, Corporate capital structure decisions are made based on. You know, I mean companies did a lot of borrowing before the Fed raised rates, right, so they obviously thought something was important.

Clem Miller: 24:43

But not the Fed funds rate. That's much less important than the 10-year treasury.

Steve Davenport: 24:49

I agree, it's a nuanced view of how 10-year treasury. I agree it's a nuanced view of how the Fed rate impacts the whole economy. It's not a direct from the overnight rate. I guess what I'm saying is, if the direction of rates is higher or direction of rates is lower, we're going to have different.

Clem Miller: 25:07

You're saying and I totally agree that there are multiple levers to what's going on with stocks and maybe the Fed is one of those levers, but there are many more levers that are involved that the Fed has absolutely no control over, and the overall investment community, especially retail investors, have much less knowledge about all the levers that go into this because of the media's overwhelming focus on the Fed. Is that about right, steve?

Steve Davenport: 25:47

Yeah, I mean I was looking for a summary and you gave it to me before I even asked. So I believe that we as a society spend too much time on the wrong issues. It's about your time in the market, not timing the market right. If you look at all the research. Lower your fees, be more patient and stay in the market through bad times and good, and work on your savings so that you have more alternatives available to you in your financial future. All of those things have nothing to do with the Fed.

Steve Davenport: 26:25

When I look at an individual, should an individual spend time thinking about whether Steve Leisman is being overly bearish or bullish? Steve Leisman is just another person who has an opinion. I look at it and say save, invest, do it for a long period of time. Not trade, but invest, and do it in a way that's effective, meaning hopefully your fees are not too high. I think that most of the people would walk away with. I got something that's going to be very helpful to me.

Steve Davenport: 27:01

Now I know what to avoid, because I think if we spend our time only focusing on what we do, we also have to spend our time focusing on what we don't do. Let's not focus on the Fed and if we make that decision all of a sudden, I've given a person you know an hour a month that they can now go and do something else in their life. It's going to give them more joy and more results, right yeah? So thanks for listening today. We hope you enjoyed the Skeptic's Guide and we hope all of you will continue to listen and continue to enjoy what we do. If you have any ideas, please call us or email or text. Thank you.