April 5, 2019
People can do some of the craziest things to get attention. I’ll never forget a childhood experience I had attempting to be noticed. I was 12 years old and playing outside with my best friend Joe. We were on top of a hill and spotted two girls on their bikes on an adjacent hill. At this point in our lives, we didn’t understand how to get the attention of girls, or even if we should. Nevertheless, on this day Joe and I decided to give it a try.
To successfully introduce ourselves, we needed to overcome two obstacles. First, we didn’t know how to introduce ourselves. Outside of school, we had very little experience meeting girls. The second obstacle was more challenging and real. Separating us from the girls flowed a large creek that was flooding from recent rains. In fact, it looked more like a white water rapid!
Despite these challenges, we were determined to meet the girls. As we began to brainstorm, one of us came up with a brilliant idea that, to this day, neither of us will admit to contriving. Our plan was to jump into the flooded creek, pretend to be drowning, and watch the girls come running to our rescue. Not a bad idea for a couple of 12-year old kids, right?
Excited to pull off our foolproof plan, we ran down the hill and jumped into the flooded creek. I remember two things after entering the water – it was very cold, and the current was very strong. To prevent us from being swept away, we held on to tree roots sticking out of the creek’s bank. After a brief panic, we regained our balance and looked up to the hill to see if the girls were still there. Yes, they were and yes, they noticed us. The plan was working!
It was time to implement the final phase. With our free arms, we began waving to the girls and yelling for help, “Come save us, come save us!” But instead of running down the hill, they simply stood there staring at us. Why weren’t they answering our calls for help? Maybe they were mean girls. Maybe they weren’t worth risking our lives for after all! Were they really just going to stand there and watch us drown? We weren’t sure, but one thing was certain—we were very cold, and it was getting harder to fight the current. We needed to get out of the creek soon.
Unaware of it at the time, our rescue operation was well underway. Unfortunately, it wasn’t the girls coming to our aid—it was an alarmed parent (Joe’s neighbor). After seeing us wave our arms and yell for help, Joe’s neighbor sprinted frantically down the hill to save us. Just as our rescuer arrived, we decided to abort the mission and pulled ourselves out of the creek.
Joe’s neighbor was exhausted from his downhill dash and was noticeably shaken. As he attempted to catch his breath, he asked if we were safe. Soaked in muddy creek water and shivering, we said we were fine and explained why we jumped into the creek and pretended to be drowning. Needless to say, Joe’s neighbor did not share our appreciation or enthusiasm for the plan.
In the end, we never met the girls, Joe was grounded, and I was sent home. Nevertheless, we learned several valuable lessons that day, including: 1) don’t enter flooded waterways (Turn Around Don’t Drown); 2) incorporate multiple outcomes in every scenario analysis; and 3) properly consider the risks of complex greeting techniques.
Throughout the current market cycle, there have been several episodes of investors appearing distressed and calling out for help. The most recent period occurred in Q4 2018. For the three months ending December 31, 2018, the S&P 500 and Russell 2000 fell -13.5% and -20.2%, respectively. Similar to Joe’s neighbor, the Federal Reserve heard investors’ cries for help and came running to their rescue. Specifically, during the last FOMC meeting, the Federal Reserve announced its intention to refrain from raising the fed funds rate in 2019 and to wind down quantitative tightening by the end of September.
In my opinion, the actions of investors, central banks, and financial markets are becoming increasingly predictable. Investors appear distressed, central banks respond by easing policy (or rhetoric), and another leg up in this seemingly endless 10-year bull market begins. It’s getting so predictable, I often wonder if investors are intentionally putting themselves in harm’s way to trigger another round of central bank response and ultimately extend the current bull market. From my perspective, investors are implementing their own version of “I’m drowning, save me.”
Whether the strategy is intentional or not, investors and central banks appear to be benefiting. Investors benefit from the perceived central bank backstop (the Fed put), historically low interest rates, and a prolonged period of rising asset prices. Central banks, and the governments they represent, benefit as well. Rising asset prices can stimulate the economy, profits, capital gains, and tax revenue. Central bank intervention can also reduce the government’s cost of capital, and in the case of quantitative easing, directly fund fiscal deficits.
Despite the beneficial relationship investors and central banks have formed, the ability of central banks to respond to every market decline or financial crisis is not guaranteed. Potential catalysts that could restrict future central bank responses include an increase in inflation, rising fiscal deficits, and an unexpected shift in investor psychology. In effect, anything that causes the bond or currency markets to become less cooperative is a risk to future central bank intervention. This includes events and trends outside of the financial markets, such as those initiated by the general public or voting booth. If a politician could ever figure out how to effectively communicate the linkage between monetary policy and rising wealth inequality—look out, changes could come fast and furious.
Regardless of the catalyst that ultimately ends this cycle’s “I’m drowning, save me” routine between investors and central banks, Palm Valley has no intention of speculating on its future. Nevertheless, we believe it’s only a matter of time before investors jump back into the flooding waters and call for the Fed’s help. When they do, we believe our positioning will prepare us for multiple scenarios, including the day when investors plunge into the white water and the Federal Reserve is unable to come to their rescue. It will be that day when we believe the buyer of last resort will shift from central banks to investors who maintained strong balance sheets and abundant liquidity. We look forward to that day with great enthusiasm!
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Definitions:
FOMC (Federal Open Market Committee): The FOMC is a committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.
S&P 500: The Standard & Poor's 500 Index is an American stock market index based on the market capitalizations of 500 large companies.
Russell 2000: The Russell 2000 Index is an American small-cap stock market index based on the market capitalizations of the bottom 2,000 companies in the Russell 3000 Index.
It is not possible to invest directly in an index.