I have always been a value investor.
It always made sense to me that prices can be off-market for short periods of time, but tend to revert to the appropriate clearing level, acting as an equalizer between supply and demand. Basically, different views on value compete in the open marketplace until prices settle. We've all seen this mechanism in action time and time again.
That new restaurant that opened recently down the street is a great example. You try it once and come away satisfied with the food, but a lot lighter in the wallet than you had expected. What's your reaction? "Well, they might make it, but they'll have to lower their prices first."
The opposite end of the spectrum is equally compelling. Though there is a lot of empty retail space in my neighborhood, there is one gutted space that is very attractive in terms of both curb appeal and access. We can't pass by without my wife commenting that a shop should really move in there. What kind of shop doesn't matter to her — it's the fact such a good location is going to waste.
Of course, this won't happen until some entrepreneur believes he or she can earn enough to cover costs and earn an appropriate return. In the meantime, available space nearby can be had at a cheaper rate, so is this particular location really worth the asking price?
The same is happening every day in the financial markets. Stock prices are up nearly 60 percent from their lows in March, driving valuations ever higher. At the same time, short-term bond yields continue to drive downward, reflecting both the scarcity of new issues and the heightened level of risk aversion.
On the equity side, there has been a significant reversal of the flight to quality trade we saw last fall. Specifically, money market funds rose first from $2 trillion in total balances pre-crises to a peak of $3.9 trillion before falling back to the current level of $3.4 trillion. This marginal $500 billion of buying power has certainly helped fuel the risk markets.
At the same time, the Fed-supplied liquidity and indirect support programs for these markets surely have encouraged a "piggyback" strategy by non-government related investors. These speculators are riding the wave of government support, hoping to time their exit efficiently.
Meanwhile, the Fed consistently tells us they have all kinds of ways to rein in stimulus, but remains silent as to when they will begin aggressively pulling on the reins. If they do so on a timely basis, the market should transition from government supported valuations to fundamental earnings based valuations without significant disruption.
However, a perfectly timed exit is not likely at all given the complexity of the situation. But the Fed can flatten the roller-coaster ride during this time by making the appropriate moves at the appropriate times. The question is not whether they will get it exactly right. The question is how close to bull's-eye will they shoot?
Key Developments
Two measures of consumer confidence declined in October. Both the Conference Board's consumer confidence index and the University of Michigan's consumer sentiment index dropped. Or perhaps it's more appropriate to say both measures fell back to their "new normal" low levels after bouncing in September.
Gross domestic production jumped in the third quarter, expanding at a 3.5 percent rate including a rebound in consumer spending, a rebuilding of inventories, solid residential investment and a jump in government spending. This is most likely the bounce off the bottom we've been waiting for, but is not necessarily indicative of future, consistent growth.
The employment cost index rose 0.4 percent in the third quarter and just 1.5 percent over the previous year. This was the slowest growth rate in compensation since spring 1982. Subdued growth in both wage and benefit costs held back employment costs which seem to be growing at a pace consistent with current inflation.
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