Prior to the Federal Reserve’s policy decision on Thursday we took some preemptive action.  Here are our thoughts on the economic backdrop, possible paths for the economy and implications of the Fed’s actions announced on the 13th.

At his speech in Jackson Hole, Ben Bernanke signaled likely policy intervention forth coming from this past week’s FOMC meeting.  Anticipation of this action caused equity markets to rally moderately.

Our thoughts on possible policy scenarios leading into the meeting:

  • The Fed meets market expectations and announces QE3:  The market, largely anticipating this scenario, would provide little additional upside.
  • The Fed disappoints the market and continues its “supportive as needed” stance to policy intervention.  The market is disappointed and sells off.
  • The Fed exceeds market expectations and provides out-sized liquidity provisions.  The market would see a short term spike.  But, this would be a long term negative given the likelihood of imbalances arising from such a policy.  Any market rally is would be capped.
  • Any Fed action would be confirmation of the current weakness in global economic data; and, it would show that the Fed is concerned about the implications.

The meeting, seemingly, provided a poor risk/return equation for our clients and given our bullish tilt, we decided to sell risk in tactical portfolios.

Actions:
Global Opportunities
  1. Rebalance PM and BIIB back to target weight.  Here, we are taking some money off the table in 2 stocks that have been portfolio darlings.  High valuations in tobacco stocks such as PM leave less room for future profits.  BIIB is up 71% since being added to the portfolio.  Tax consequence are now valued at long term capital gains rates.
  2. Sell LOW, a company attempting to expand into Canada and battle inventory issues caused by the extended softness in the real estate sector.  The Canadian real estate sector has been the recent beneficiary of commodity strength and credit creation.  Buying-in now may not be the right move.  Management, facing large challenges, continues poor execution, the brand is struggling to compete against rivals.
  3. Sell TTM, an Indian auto company with global reach.  This company has struggled in the face of global economic weakness.  Downside risks exist because of the waning performance of the global economy.  The company may be helped by global currency devaluation, but this signals alarms for future revenue as well.
  4. Rebalance VXX to target.  After signaling intervention at his Jackson Hole speech, volatility was sold.  The marketplace became confident in the likely near term stock market action given its expectation for Fed support.  In response they sold volatility, attempting to make a quick buck.  But, the need for intervention is recognition of on-going problems and potential future volatility.  The Fed can lend support, but they cannot heal.  The risks of future volatility remain and Fed action confirms this.  This was a cost averaging addition to current holdings.
World Allocation:
  1. Rebalance domestic equities IVV back to target, IWN to a lower target and QQQ to target.  Domestic equity markets have appreciated 15-23% year to date and have handily out-performed other global asset classes.  We rebalance asset exposures periodically and target 15-18% strategic over or under exposure as a signal of an increased probability that returns will mean revert.  Fed intervention often causes dollar weakness which can signal future problems.  Small cap value stocks have greater risk exposure; we have reduced the target on this asset class by 2%.
  2. Rebalance VXX to target. See above.

The Fed announcement, subsequent to these moves, was quantitative easing in excess of market expectations.  Absent our pre-emptive moves, portfolios would have performed about .25-.5% better following the announcement.  Here are my takeaways from this week’s Fed decision.

The surprising size of the Fed’s quantitative easing program, announced Thursday, indicates their concern about the global economy.  Perhaps the liquidity provisions are positive for markets in the short term, but all is not well.  A new money creation program of this size places additional future risks into the equation.  Future imbalances are now more likely; and, we would expect them to be larger.  This equates to a higher probability for a larger future bubble.  As such, the potential for future volatility has increased, risk has increased.  The liquidity provisions can produce higher valuations, but the prudent investor would be wise to take some risk off the table.

The Fed announcement rallied markets, but a look below the headlines has us concerned.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Douglas R. Terry, CFA is reachable at: dterry@4kb.d43.myftpupload.com