Written by Nate White, Chief Investment Officer of Paragon Wealth Management

As a father of five this “famous” phrase from Buzz Lightyear
of Toy Story fame is well known around our house.  I’m afraid this phrase is hanging from banners at Ben Bernanke’s office and other areas of the Federal Reserve in regards to the infamous program now known as Quantitative Easing or QE.  After seeing the market tank both times after ending QE1 and QE2 the Fed wised up this time and decided to leave the newest QE round as “open-ended”.  The Fed balance sheet stands at nearly $3 trillion and growing.

The problem with these programs, as I have stated regularly,
is that the benefits are not worth the costs in the long-run.  Much has been said and written about the potential inflationary ramifications of the Fed’s actions but there are other effects to consider as well.

First, attempting to artificially keep assets prices high does not fix an economy and can actually cause harm by distorting the all-important price signals needed to aid in the allocation of resources.  I agree with Jim Grant, editor of Grants’ Interest Rate Observer, who
remarked that today’s capital markets now resemble of house of mirrors.   For example, the market is currently trading at about 14.8 times earnings which historically is on the cheap side and relative to interest rates even cheaper still.  However, interest rates are a
significant factor in determining the level of valuations and so the question becomes where would valuations actually be if interest rates were not being kept at these “artificial” low levels?  This
makes it difficult to confidently make forecasts and economic decisions resulting in uncertainty which tempers investment and the economy.   The low rate environment is confusing for investors and damaging to savers.  It effectively forces people into investments
that they might not otherwise own and that possess greater risk than is appropriate.

Secondly, as the Fed’s balance sheet continues to massively
expand it will act as a drag in the future when the process must be reversed.  The Fed cannot fix what ails today’s economy.  They cannot push borrowing rates any lower and unless they are going to lend directly to the public or “instruct” the banks to do so there is not much benefit that can come from buying $40 billion a month of mortgage securities and then possibly tens of billions more in
Treasuries.  In fact, the continued purchase of Treasuries is causing the government to become more reliant on the Fed for funding and giving it the perception that the cost of providing public goods is virtually zero.  In 2011 the Federal Reserve purchased about 77% of the additional debt issued by the Treasury (Wall Street Journal, Phil Gramm & John Taylor – 9/11/2012). Without the discipline that a “real” or truer interest rate would provide a vicious cycle of ever expanding government is created.  This process leaves governments and economies extremely vulnerable to economic shocks.  If inflation or the economy picked up the Fed would have to stop buying Treasuries and start selling them putting upward
pressure on rates.  As interest rates rise the earnings multiple (P/E) of the market tends to go down putting a damper on potential returns.  The private sector has been deleveraging since the financial crisis while the public sector has done the opposite.  As seen with
Europe today, rising rates quickly reveal the true burden to large debt loads.   Due to their debt burdens, far too many state and local governments would have significant difficulty financing themselves in a slow growth rising rate environment.  Watch for a build-up of pressure for the Federal government to guarantee state and local debt as is already happening with public pensions.

Now that I’ve discussed some of the potential downsides of the Fed action how does that affect us in the here and now?  In the short run, the Fed’s continued easy money policy is supportive of asset prices.
The popular adage of “don’t fight the Fed” has a lot of merit because
all those billions have quite literally got to go somewhere.  I wouldn’t want to fight against someone who has unlimited ammunition! Fighting the Fed can be hazardous to your portfolio’s health.

While the Fed’s actions can affect markets and the economy it is just one piece of the puzzle.  The upcoming elections and the looming fiscal cliff are obvious factors as well.  Trying to discern how much of
these factors are priced into the market is very difficult to ascertain.  Any selling for political reasons, no matter how seemingly justified, could be very short-lived and ultimately backfire.  The European crisis still continues to be an influence in an off and on again manner.

At the current valuation of about 14.8 times earnings the market is still at about a 10% discount to the 50 year average of 16.4. Corporate balance sheets are still in good shape and the real-estate market, while not off to the races, has begun to turn around.

Our current strategy is still a bit cautious ahead of the elections
and fiscal cliff worries with Europe always in the background as a recurring potential mess.  Valuations generally keep us positive but we are getting closer to the “upper end” of the range and better
economic growth would be needed support more robust gains going forward.  We still view stocks better than bonds and are minimizing interest rate risk in our Managed Income portfolio.   Many income oriented assets are getting stretched as investors stretch for yield and so we have taken some profits and will look for better entries on pullbacks. We are also looking at seasonal plays, possibly shorting bonds on rallies and adding to cyclical sector exposure on pullbacks as tactics to employ going forward.

We believe that it is important to keep invested because we could be entering an environment where returns are hard to come by and so you will need every bit of what is available.

Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.