Central Bank Noise. Investor Behavior. Colliding Objectives.

December 17, 2021

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“Wherever there is prediction, there is ignorance, and probably more of it than we think.”      Daniel Kahneman, #Noise

“The investor’s chief problem – and even his worst enemy – is likely to be himself.”     Benjamin Graham

“Hell is the truth seen too late.”    Thomas Hobbes

The media noise about the Fed’s pronouncements does not get investors anywhere close to an optimal and timely decision process. 

The Federal Reserve has shown again, in 2021, that it’s decision process is reactive with a considerable lag. It has taken 40 year highs in inflation for it to take any action at all. Now it’s removing just a small part of its economic stimulus. It will still be some time before there is anything that looks like an inflation constraint. 

The Federal Reserve compounds it’s timing problem by committing to its own “judgement”.  No matter how poor their own forecasts have been or how relentless the 50 year downtrend in long term growth in the economy, and the purchasing power of the dollar, the Fed never seems to question, let alone develop, its own decision process. The persistent errors accumulate to deliver a tragic 50 year track record. 

Daniel Kahneman explains how economic and investment process has moved on: 

“Despite all of the evidence in favor of mechanical and algorithmic prediction methods, many decision makers will reject decision-making approaches that deprive them of the ability to exercise their intuition…

As long as algorithms are not nearly perfect – and, in many domains, objective ignorance dictates that they will never be –  human judgment will not be replaced.” -Kahneman

Back to the Fed.

Now that the Fed admits it’s own inflation “judgement” has been late, it may be about to make another error. The Fed thinks its “time” to consider raising interest rates. Meanwhile, the market is signalling it has switched to the opposite side. The market is signalling that the highs in bond yields and interest rate expectations are in for now! 

“The market continues to doubt the FOMC’s dot plot, viewing it as too hawkish. The rate trajectory implied by the fed funds futures shifted further below the FOMC’s forecasts.”

Image

https://twitter.com/SoberLook/status/1471789650306125828

The last time the Fed tried a taper/rate hike exercise (2013-2018) they caused the stock market to crash 20% (Oct-Dec 2018) then they reversed course. This time the tempo will be faster. So should we expect the market to crash sooner?

Here is a deeper read on how concerned the Fed is on this issue and its conflicting objectives. This shows the Fed, for all its staements, is highly discretionary in practice.

https://northmantrader.com/2021/12/16/the-unraveling/

Collision course: Global monetary tightening cycles are beginning amid record valuations.

As the Fed talks tough about the speed of tightening policy, they are also clearly concerned about how high the beginning equity valuations are. It is also clear from how quickly they support market setbacks. How will they support markets while they are tapering? They say they will be flexible!

For all the excessive narratives and talks from Fed speakers, this does not provide much clarity. After all, current growth has rarely been higher, while financial conditions have never been more supportive. What are their real priorities. I guess we will have to find out.

“A global monetary tightening cycle may end up highlighting one of the weaknesses of purely discretionary policy. Investors have no observable policy guideline to anchor their expectations.” 

“A global tightening cycle here would start amid record valuation levels relative to prior tightening cycles.”

 

Tightening cycles are beginning at record valuations

https://www.hussmanfunds.com/research/rs211211/

Investment behavior has met all the conditions for a bubble high. The Fed’s monetary tightening cycle is beginning with investors at extreme bullish sentiment, leverage, and positions.

In the link below, Charles Hugh Smith articulates six necessary behavioral conditions for a bubble high to be in place. The bull market has gone on for so long and gone so high that past crashes seem like a distant memory and a new generation of investors has not even experienced what a crash is like. Here is the last condition which represents what could be described as “catch 22” magical thinking about the powers of the Fed.

Can the Fed contain inflation while continuing to support the market at record valuation levels?

“Punters are confident that the Federal Reserve will manage to tamp down inflation while keeping the stock market at a permanently high plateau. Never mind rising real rates, never mind the need to reduce monetary stimulus as the only means to take the air out of inflation–the Fed will never let stocks decline. The Fed Put is unbreakable.”

https://www.oftwominds.com/blogdec21/crash-positions12-21.html

The Fed won’t change but investors can do so much better with their own more optimal process. Observe the Fed, but don’t bet your future on this institution.

While the Federal Reserve is powerful and consequential, this appears to manifest more in market and economic distortions rather than in clearly beneficial results in terms of it’s stated goals for growth and inflation. It is obviously important to track the Fed, but they are so far behind investment developments “Best Investors” must find a way to be well ahead of the Fed. A process handicapped by timing and judgement issues can only go so far. You can’t think like they do and be optimal.

Investors can take their process to a much higher level and then enjoy a sustainable advantage:

https://geni.us/InvestLiketheBest

 

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