The biggest risk to the markets this week was Fed Chairman Ben Bernanke’s testimony before congress. Despite worries that he would say something that would send the markets into a tail spin, he did nothing of the sort. When it comes to the Fed, Wall Street may be its own worst enemy, and here’s why.
Investors, for the most part, have an irritating habit of breaking down the most complicated of issues into something naively simple. Most end up something like this: if X occurred, then Y will happen. Usually, these simplistic conclusions are way off base. Nonetheless, the markets trade up and down, sometimes violently, on the basis of these naive outcomes. Take the notion that the Fed will hike interest rates as soon as the unemployment rate reaches 6.5%. To the markets, it is cut and dry.
We live with the myth that the Fed’s actions are totally dependent on that unemployment number. Investors wait with bated breath each week for the unemployment data to be announced. Stocks and bonds react sharply with billions won or lost on the outcome. Keep in mind that this data is at best cumulative, highly inaccurate and usually revised up or down several times before the final number is tallied. Yet, the markets react as if each data point is the big one and that the Fed has its finger on the interest rate trigger all the time.
Never mind that the Fed has gone to great lengths to explain that 6.5% is not the instant trigger we believe it is. They recognize, as should you, that unemployment statistics can be extremely misleading. Sometimes the unemployment rate declines simply because some workers give up looking for a job and are therefore no longer counted as unemployed.
There is also such a thing as structural unemployment where, despite their best efforts, some Americans cannot find a job because they lack the education, skills, health or some other longer-term obstacle to employment. Then there are those who are working part-time. These are under-employed workers who are seeking full-time jobs or over-qualified workers who can’t find a position that is equal to their job skills.
None of the above would be accounted for when looking at a headline unemployment rate such as 6.5%. The Fed understands this. To them, despite a 6.5% unemployment rate, the economy might still be too weak in employment terms to warrant a hike in interest rates.
Likely as not, however, when we hit that 6.5% rate, the markets will sell off fearing the worst. And if at that time, the Fed decides not to take action on the rate side, investors will scratch their head, accuse the Fed of bluffing or some other ridiculous accusation and then go on to the next nonsensical either/or event.
Readers should take away a few things from this example. Number one, like most things in life, simple black or white outcomes are rare. Yet, few investors take the time and effort required to understand the nuances of these issues. And most of the events on Wall Street that are labeled as “do or die,” end up as non-events, so short-lived that few even remember what they were so worried about a month later.
So how do you deal with this constant noise? First, you need to do your homework and discover the truth about these issues. Second, keep your eye on the bigger picture. That’s what matters. Things like whether the economy is growing or not or if interest rates overall are expected to rise and if so what you should do about it. That is where I like to focus because if you can correctly identify a trend, then you don’t need to sweat the small stuff. The trend is your friend and in this case it is still up, at least in the equity markets. The bond market, as my readers understand, is a different story.