When I was in high school I remember taking a first-aid class and learning about treatments for various ailments resulting from accidents or emergencies. One antidote was for frostbite: rub snow on the frostbitten limb and that would alleviate the problem. Another remedy was for a serious burn: put butter or Crisco on it.
As we know all too well today, these treatments turned out to be great fallacies. But when I hear some journalists, portfolio managers, and economists providing insights on the financial markets, I sometimes think that I’m once again being told to rub snow on a wound. While their insights seem logical enough when given, they are exposed as falsehoods when you take a closer look.
Here are five financial-market “snow jobs” now making the rounds:
1. Investors Are Getting “Back Into the Market.”
Here is a quote from a recent Wall Street Journal analysis: “After the three-year bear market, many investors are starting to wade back into the stock market again.” While an investor might decide to buy stocks, investors in aggregate cannot buy stocks. Think about it! The stock market is a place where buyers and sellers meet to exchange their stocks (stock exchange, get it?). So, for all those buyers, there must be an equivalent amount of sellers. At the end of the day, there is the same amount of stock, and the same amount of money. Only two things have changed: the prices of stocks and who holds the money. If the buyers prevail, stock prices will rise; if sellers prevail stock prices will fall. However there is no money going into the market. A corollary to this belief is the analysis that money is flowing out of bonds and into stocks or vice versa. At least the media commentators love to provide this analysis when these two markets diverge. It’s been tough for them lately with both the bond and stock markets going up.
2. The Federal Reserve Controls the Money Supply.
“All we need now to get the economy growing is for the Fed to keep pumping reserves into the system.” The Federal Reserve, as the keeper of the monetary gate, can produce money in the form of bank reserves otherwise known as the monetary base. The price of this money is the federal funds rate, or the rate that banks that are members of the Federal Reserve charge for lending each other required reserves. Basic economics teaches us that the producer of a good can determine either the price of something or the quantity but not both simultaneously. Since the Fed focuses on setting the price of money (fed funds rate) as announced at periodic Federal Reserve board meetings, it is therefore obvious that it cannot control the quantity of money simultaneously. If the Fed embarked on the exercise of pumping in excess reserves to a banking system that shuns holding excess reserves (because they don’t earn interest) then the fed funds rate would quickly fall to zero.
3. Mutual Fund Performance Reports Accurately Reflect Investor Returns.
Mutual fund companies and independent sources such as Lipper and Morningstar provide investors with detailed analysis of the performance of mutual funds. The National Association of Securities Dealers (NASD) goes so far as to stipulate what time periods a mutual fund company must report performance data to clients and potential customers. The problem with these performance statistics is that they do not accurately reflect the performance of the fund relative to all investors in that fund. The problem is compounded by the fact that mutual fund companies promote their best performing funds and attract new investors who seek to benefit from this past performance. The traditional measurement technique to calculate investment performance is a time-weighted rate-of-return calculation that eliminates the effects of cash flows into or out of the fund. The traditional argument for using this approach is that portfolio managers can’t control the money going into or out of their funds. However, mutual fund companies do influence the money flowing into and out of selected funds. Under these circumstances, the appropriate measure of investment performance is dollar-weighted rates of return. By determining the total returns of all investors in the fund, not just the ones who were there when performance was superior, investors will get an accurate view of how mutual fund companies manipulate investment performance and mislead investors who have Morningstars in their eyes.
4. Federal Budget Deficits Drive Interest Rates Higher.
Politicians are deploring President Bush’s latest tax-cut stimulus package even after they reduced his proposed $700 billion package to about half that amount. In spite of this reduction, opponents are still forecasting higher interest rates as a result of the budget deficit. One would think that an estimated $400 billion deficit this year down from a $200 billion surplus in 2000 (that is a swing of $600 billion) would put some upward pressure on interest rates. Yet interest rates have recently plunged to fifty-year lows! Three-month Treasury bills yield less than 1 percent and 5-year treasuries are close to yielding only 2 percent. In reality, the Federal Reserve controls interest rates, and whether it is long or short rates they will go where the Fed wants them to go regardless of the size of the budget deficit. If you think our experience is unique, check out Japan where huge budget deficits coexist with virtually zero interest rates.
5. What This Country Needs Is Higher Savings.
I am sure you have heard more than one economist or politician bemoan low savings rates in the U.S. as if higher savings rates would somehow help the economy. I guess these guys think that increased savings means more capital for business investment. How silly is that! In aggregate, one person’s savings is another person’s income. If I decide to spend less and save more, then someone else won’t have that income. The economy slows as a result and there is less need for capital investment. And banks can lend money unconstrained by the size of their checkbooks, so if businesses want to borrow to increase capital expenditures, there doesn’t have to be a higher level of savings to accomplish that end. However, the most important aspect of savings is deficit spending by the government. When the government runs a budget deficit it creates private sector savings. Or, when the government runs a surplus (another term for government saving) then the non-government or private sector runs a deficit, i.e. less saving. So if the politicians want greater savings, they will have to run a bigger deficit.
— Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc. and an investment consultant for Wealth Management Services of South Carolina.