Free Pass for the Markets

Back in the fall of 2010, big-time hedge fund manager David Tepper made headlines when he pronounced that everything was a buy going forward due to the Fed’s likely implementation of QE2. Tepper opined that with the Fed looking to push “asset prices” higher, it made sense to play along with Bernanke’s plan. The ensuing rally became known as the “Tepper Trade” as, true to his prognostication, just about everything in sight embarked on an upward path for the next six months.

This trade worked exceptionally well as stocks marched higher with nary an interruption until the messy stuff started happening in mid-February. After a strong surge in stock prices, which amounted to something on the order of +28% for the S&P 500 from September 1, 2010 through February 18th, the uprisings in the Mideast and North Africa, the resurgence of debt difficulties in the Eurozone, and the triple tragedies in Japan caused investors to rethink the Tepper Trade – well, for about a month, anyway.

In addition, during this time, we started to hear more and more hawkish commentary coming out of the Fed as folks like Dallas Fed President Richard Fisher began to publically lament about the prospects for inflation. By mid-March, traders had become convinced that the combination of the geopolitical problems and supply interruptions (as well as the potential for a nuclear disaster) in Japan would cause the global economy to slow. And after a six-month hiatus, the bears appeared to be back.

Of course, that was BEFORE Ben Bernanke started doing his darndest to communicate the Fed’s stance to the markets. Say what you will about our Fed Chairman, but it is clear that Gentle Ben is bound and determined to keep the U.S. economy out of deflationary spiral. As one of the foremost scholars on the Great Depression, Bernanke knows that once deflation sets in, it can be VERY difficult to reverse. So, Bernanke’s answer is simple – make stuff go up in value.

In my humble opinion, what we are seeing now in the stock market is the realization that the Fed’s “Free Pass” for the markets continues to be in play. On Wednesday, Mr. Bernanke said that inflation isn’t a problem from a bigger-picture standpoint and that employment isn’t where he would like it to be. Therefore, the Fed is going to keep the ZIRP (zero interest rate policy) in place “for an extended period.”

To traders, this means that it’s okay to “Party on Wayne” with regard to the “risk trade.” And for those of you that still may not understand how this particular “trade” works, let’s break it down. With the Fed saying it isn’t worried about the dollar, traders basically have a free pass to sell the dollar short. Of course, this means that you are selling something that you don’t own, which puts cash into your account. So, what do you do with that cash? You buy stuff that benefits from the dollar’s decline (which you are helping to further) such as commodities, emerging markets, and big multinational companies that tend to see increases in earnings from the currency play.

How long will this “free pass” to higher stock prices last, you ask? Obviously no one knows for sure, but until either the Fed decides to change its tune or the economy encounters something that causes growth to slow, it is probably best to continue to lean on the “buy the dips” strategy.

Turning to this morning… With all eyes on the Royal Wedding in London, the markets are fairly quiet in the early going. However, strong earnings from Caterpillar (CAT) seemed to improve the mood a few minutes ago on the DJIA.

On the Economic front… Personal Incomes rose by +0.5% in March, which was above the consensus expectations for an increase of +0.4%. The February level was revised higher to +0.5%. Personal Spending (now called “Consumption”) for the month rose by +0.6%, which was in line with the expectations of +0.6% but below the February revised reading of +0.9% On the inflation front, the Core PCE (personal consumption expenditures) came in up +0.1%, which was below expectations for +0.1%.

Finally, the Employment Cost Index during Q1 2011 was reported at +0.6%, which was a tenth above expectations.

David D. Moenning
Editor:  The Daily Decision