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Worrying about the Fed is a waste of time

Investors need to focus on business profitability


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One of the new challenges in the financial markets over the last seven years is the growing involvement of government entities. What we mean by that is the direct intervention in financial markets by central banks (like our Federal Reserve or the European Central Bank) and other government-sponsored actors. While government regulation of markets is needed to ensure a level playing, things start to get distorted when governments go from being the "referees" to the players.

Over the last seven years, governments have gotten involved in manipulating interest rates, direct purchases in the bond markets, direct bail-outs of industries, direct bail-outs of other governments and sometimes direct intervention in stock markets. This activity often distorts a more rational allocation of investment capital and has contributed to some of the more violent market moves we've seen over the last few years.

The main problem is that governments can deploy lots of resources and influence short-term market dynamics in a big way. They are sort of like a "bull in a china shop." Because their activity can move markets, investors often implement investment strategies that they think will benefit from anticipated government actions. But many of these strategies are things investors wouldn't otherwise pursue except for the fact they think they can benefit from the market moving effects of government intervention. These strategies can reach across multiple asset classes like stocks, bonds, real estate, commodities and currencies.

For instance, let's assume that we were aggressive traders focused on trying to bet on daily or weekly market price movements. If we think a government sponsored entity may "bail-out" a country that is close to defaulting on its bonds, we may buy those bonds at a big discount in hopes that when the bail-out is announced, the bonds will rapidly rise in value and we'll make tons of money. But if we get the slightest hint that the bail-out might not happen, we have to run for the exits ... and hope we are faster than the other guy who has made the same bet. This creates a ton of volatility. Whereas, if there were no anticipated bail-out, we may never have bought those bonds in the first place.

Or, maybe we think the Fed will raise interest rates and we put into place trades that would benefit from that increase. But if the Fed doesn't raise rates, off we go again to the races.

Or let's say we see a foreign stock market crashing and we think a large government entity may get involved in buying and propping up that market We might invest big in that stock market hoping it will bounce back once the government starts buying. But if we sense the government entity might not get involved or that what they are doing isn't working, then again, we have to head for the exits. Yet without the anticipated government involvement, we may never have invested in those stocks.                                                                             

This is how direct government action in financial markets can distort a more rational allocation of capital. Governments often get involved with good intentions, usually with the goal of calming or stabilizing markets; but, their actions may actually create the more volatile results they are trying to avoid.

While there is never just one reason for market movements, we think that the growing involvement of government entities (in the U.S., Europe and Asian markets) has exacerbated the recent sharp and irrational market movements. We expect it will continue as central planners now feel compelled to play out the hands they dealt themselves. The heavy global government intervention is one aspect of our current markets that didn't exist much in the past. It's important to recognize this new dynamic but also put it into perspective.

While government intervention can muscle markets around, unfortunately, governments can't create or "will" more wealth. If it were that easy, then we could just pass a law that says the stock market has to go up 8 percent per year and forget about it. It's business profitability that creates sustainable shareholder wealth.

That's why we don't spend much time trying to predict what governments will do. A large percentage of our industry wastes tons of brain power in this area: Witness the millions of hours spent on the last Fed decision, which turned out to be a non-event. We think investors would be better served dedicating their research to understanding business profitability in the current markets.

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Charles Farrell

Charles Farrell is CEO of Northstar Investment Advisors, LLC, and author of "Your Money Ratios: 8 Simple Tools for Financial Security," called "one of the best financial books to cross our desks this year" by the Wall Street Journal in 2009. Farrell previously served as a tax attorney representing privately held businesses on tax, retirement and estate planning matters.

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