Force-fed Risk

Good Evening: After trading in a narrow, fitful range for most of the session, U.S. stocks edged lower on Monday. The earnings news from corporate America continued to be supportive, while a further slide in Greek securities and pending hearings about financial reform added some offsetting weight as the day wore on. After the amazing run equities have enjoyed during the past 13 months, risk appetites among market participants show few signs of waning. Prudence might normally dictate that investors edge toward the exits after an 83% rally in the S&P 500, but good alternatives are hard to find with Fed-engineered short rates still essentially at zero. That prudence was long ago abandoned by our Federal Reserve is one of the central themes of the latest Quarterly Letter by GMO’s Jeremy Grantham.

The major averages in both Asia and Europe were on the plus side overnight, with Japan’s 2%+ gain the standout among them. U.S. stock index futures were also in the green ahead of today’s trading, due to well received earnings news from Caterpillar and Whirlpool. Most companies have been exceeding analysts’ estimates during the Q1 earnings season, and these same seers are busily extrapolating the good news for quarters yet to come. What held equity prices back today, however, were items both political and geopolitical. Germany continues to demand something resembling fiscal discipline before it will give its backing to any bailout of Greece (see below). And while political tensions in Washington are nowhere near as high as they are in Athens, owners of bank stocks fretted today as the Senate geared up for tomorrow’s grilling of executives from Goldman Sachs. The release of some rather basely worded emails by senior Goldman employees about pending GS transactions was the talk of trading desks everywhere. Understandably, the bank stocks fell prey to some profit taking on the news.

After opening in plus territory, the major averages spent the rest of the day wandering above and below the unchanged mark. Some late selling left both the S&P and Russell 2000 down 0.43%, while the Dow and Dow Transports managed to hold on to fractional gains. Treasurys were also essentially unchanged, though the long end fared a little better than the short end of the curve. The dollar rose against the euro but could still only manage a modest overall gain, while commodities edged lower. A $1 drop in crude oil paced the CRB index to a decline of approximately 0.25%.

As the calendar turns to May and spring works its annual magic on foliage in the Northern Hemisphere, investor risk appetites are also in full bloom. Many major stock market averages (Russell 2000, Midcap 400, and Dow Transports) are now more than 100% off their 2009 lows; junk bonds are up almost as much (see below); and commodities like crude oil and copper sport similarly outsized gains over the same period. Bullish sentiment is on a high simmer, at least according to polls by Investors Intelligence. And a falling VIX has been the mirror image of rising sentiment. What all these positive readings have in common, according to GMO’s Jeremy Grantham, is a U.S. central bank with its foot on an accelerator pedal that might just as well have been made by Toyota.

In his latest Quarterly Letter, “Playing With Fire”, Mr. Grantham fingers the Fed as the prime suspect in the price levitation seen in our capital markets since last March. Mr. Grantham, who was one of Alan Greenspan’s earliest critics, pulls no punches when describing the Maestro’s successor, Ben S. Bernanke. He portrays Mr. Bernanke and the rest of the FOMC as purveyors of recklessly easy monetary policies that could cause yet another equity bubble to inflate by next year. Prudent savers are still receiving next to nothing on their cash, which is a doubly cruel penalty on thrift in his eyes. First, savers are foregoing hundreds of billions in lost interest, a total he sees dwarfing what he almost laughingly calls the “profit” earned on the TARP and other rescue programs. How long should the prudent have to keep bailing out the reckless?

Second, and just as pernicious to Mr. Grantham, is that Mr. Bernanke’s zero interest rate policy “begs us to speculate, and we are obedient”. A parched investment landscape, at least in terms of safe and reasonable yields, has left investors thirsty enough to imbibe more perilous alternatives like junk bonds and tech stocks. As the markets rise and more investors feel forced to participate (or be left behind), Mr. Grantham worries that the old highs might be taken out as soon as next year. He thinks the Bernanke Fed will not only tolerate the soon to be towering valuations, they will accommodate — even encourage — a kiting of various asset classes.

Will prices reach the bubble territory Mr. Grantham fears is all too possible? I doubt it, but anything can happen if the Fed keeps the hammer down into 2011. The FOMC could soon reach a point where it is force-feeding risk into an economic and financial system that is unlikely to sustain it without another accident. Mr. Grantham has other pearls of investment wisdom to offer in his letter, but his complaints about the Fed are the most notable. Perhaps I’m just old fashioned, but I think capitalism works far better when the choices made by participants are voluntary. Very few of us make sound investment decisions if they are of the “have to” variety.

— Jack McHugh

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“Playing With Fire”, Jeremy Grantham’s Quarterly Letter