¶ Relevance of Fed Watching in Investing
Hello , this is Steve Davenport from Skeptic's Guide to Investing . I'm here today with Colin Miller . 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 .
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 ? 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 .
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 . Now , I would also say that there's a certain amount of expectations theory that's involved in looking at the Fed .
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 .
They all get it wrong .
What .
Or if they all get it wrong .
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 .
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 ? 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 .
Maybe it is relevant we're just not educated enough to appreciate the subtleties .
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 . 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 .
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 .
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 .
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 .
Absolutely and to not make this idealist view of the Fed .
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 . 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 .
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 .
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 ?
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
¶ Fed Influence on Stock Market Overstated
spreads . 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 .
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 .
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 .
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 ?
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 . 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 .
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- .
MIKE GREEN . I wouldn't even , personally , I wouldn't even put them in the six .
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 .
But not the Fed funds rate . That's much less important than the 10-year treasury .
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 .
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 ?
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 .
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 .
¶ Focus on What We Don't Do
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 .