Two Tragic Reasons Why Investors Love the Fed

Evan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

After the Federal Reserve recently announced that it would start another round of stimulus spending to the tune of $40 billion a month, the Dow Jones Industrial Average rocketed 200 plus points on Thursday, September 13, 2012, while the S&P 500 Index shot up 23 points.  It’s clear that Wall Street investors are happy about this news, even as the Middle East is going up in flames.  This event and other similar ones like it beg the question: why do investors apparently love the Fed?  The exhaustive answer is not simple, but there are two overarching concepts that play a crucial role in shaping investor sentiments on the Fed’s activities.

First, investors in the market currently foster a culture of tragic shortsightedness of not valuing long-term goals. 

Secondly, the market is buying into the Fed’s policy of monetizing our debt by printing more currency, as well as endorsing our government’s feel-good endeavors to prop up the economy.  By promoting these Keynesian economic policies, the market is rewarding ideas that will unfortunately prove to be to its own detriment.

1.) A tragic shortsightedness of long term goals

In an excellent piece by Morgan Housel called “Facebook Really Was the Worst IPO of All Time,” Mr. Housel illustrates a market crisis which has crept in as the internet technology age has swept the world.  Although the ideas he espouses primarily deal with market valuation and Facebook (NASDAQ: FB), parallels can be drawn to the overall culture of the market today.  Housel writes:  “My issue [with Facebook’s IPO] can be summed up with two news headlines.  This one, from three days before the IPO: ‘Facebook IPO has individual investors lining up.’  And this one, from two weeks after the IPO: ‘Lawyers Line Up to Sue Facebook over IPO.’  If there's a better two-line summary of why so many people fail at investing, I can't think of it.  Here was a sensationally hyped company trading at a mind-numbing 100 times earnings that investors around the world were tripping over themselves to get their hands on.  And when shares didn't make them a fortune in the first 90 days, they concluded that the whole game is rigged, stomped their feet, and sued everyone in sight.  Facebook's IPO was the worst of all time because it was a perfect display of the short-term-minded, oblivious-to-risk, valuation-be-damned culture that has overtaken public markets.”

Mr. Housel describes a poignant crisis in the market today.  With the advent of the internet age and a developing culture of what can best be described as “give-it-to-me-and-give-it-to-me-NOW,” more and more stock holders are adopting a dangerously short-term mindset.  This is not to be confused with the actual, normal nature of a fast-paced market.  Although the market is fast-paced and can change on a dime, the immediate, short-term goal mentality creeping in is perilous.

This is one reason why investors love the Fed:  When the Fed throws money at the U.S. economy, it does provide some short-term benefits, albeit of questionable definiteness.  But in the long run, Federal Reserve and governmental intervention in the markets damages our economy.  Many investors today, unfortunately, do not see that so when the Fed announces more stimulus or more meddling around with interest rates, some shareholders rejoice.

The advent of the internet age is a powerful force which has impacted the stock market in many ways - some good and some bad.  One bad effect of the internet age has been already explained as the fostering of a “gimme-what-I-want-IMMEDIATELY” or a “my way or the highway” mentality.  This is just one reason why investors love the Fed.

Another example of the mindset of the “gimme generation” is that of Amazon (NASDAQ: AMZN).  Although Amazon does have some great technological gadgetry in their lineup of products, the company’s stock is questionably overvalued.  Investors are seeking immediate profits in the short term from the company.  Amazon’s stock is currently trading at an astounding 320 times earnings forecasts for fiscal year 2012.  By contrast, Apple (NASDAQ: AAPL) is trading at about 15 times future earnings.  In order to justify such a large valuation, investors have to believe that Amazon’s products, including the Kindle, will generate some serious profits down the road.   Amazon, unfortunately, does not have the numbers to back that up.  This is reminiscent of fiat currency which has absolutely nothing to back it up.

If you’re one of the fortunate ones who invested in Apple back in 1998, you’re probably reading this from your personal yacht as Apple stock has hit all-time highs.  It took time for Apple to grow into the tech giant it is today.  It takes time for businesses to grow.  And, it takes time for an economy to grow.

2.) A tragic belief in feel-good Keynesian economics

As previously mentioned, when the Fed throws money at the U.S. economy, it does provide a touchy-feely, short-term benefit.  While investors appreciate this short-term bump, the gain soon dissipates into an even worse problem than what the market originally started with.  Keynesian Federal Reserve and governmental intervention in the free market puts a major dent in our economy.

The Fed’s policy of printing our economic woes away debases and devalues our currency.  The Dollar Index, which IntercontinentalExchange uses to track the dollar against the currencies of six U.S. trading partners, declined 0.7 percent on September 14, 2012 to $78.735, after touching $78.601, the lowest since February 29, 2012.  The dollar typically declines after the Federal Reserve tampers with the economy.

According to basic economic theory, the Gross Domestic Product (GDP) of a country is summed up by this formula:

GDP = private consumption + gross investment + government spending + (exports − imports)

Simply put, according to Keynesian economic theory, if you increase the amount of government spending or increase the money supply, then the overall GDP will increase as well.  This seems to make perfect sense theoretically.  However, it doesn’t take into account one very important aspect:  When government spending goes up, whether by actual spending or monetizing the debt, private consumption and gross investment goes down.  Thus, economic activity and the overall GDP of a nation decreases.

Ludwig Von Mises and Friedrich August von Hayek, the famed Austrian economists, give us cogent advice on how the market works in contrast to the belief in employing Keynesian tactics.

“Even the striving for equality by means of a directed economy can result only in an officially enforced inequality - an authoritarian determination of the status of each individual in the new hierarchical order.” –Von Hayek

 “Government is a guarantor of liberty and is compatible with liberty only if its range is adequately restricted to the preservation of what is called economic freedom.” –Von Mises, Human Action

 “It is certainly true that the necessity of adjusting oneself again and again to changing conditions is onerous.  But change is the essence of life.  In an unhampered market economy the absence of security, i.e., the absence of protection for vested interests, is the principle that makes for a steady improvement in material well-being.” –Von Mises, Human Action

What these quotations demonstrate is that the pathway to prosperity is paved not simply by good intentions, but by common sense, rational, sound economic policy built on the foundations of freedom.  Albert Camus, the French philosopher, once eloquently said:  “The evil that is in the world almost always comes of ignorance, and good intentions may do as much harm as malevolence if they lack understanding.”

Lawrence W. Reed, President of the Foundation for Economic Education (FEE), also excellently points out the unintended consequences of governmental policies:  “Because of a raft of restrictive barriers to enterprise, we pay for government in terms of businesses stymied or never started and jobs never created.”  This lack of enterprise will eventually drive down shareholder value.

Investors today are erroneously apt to love the Fed and governmental intervention and its short term benefits, rather than value the free market system which made America great and powerful in the first place.  Hopefully soon, these shareholders will “return to their first love” and reallocate their misplaced affections.

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