The following is an excerpt from a Market Comment recently featured on TFR Premium.
I think there are times in the markets when it is useful to perform a certain sort of thought experiment. I have heard Stan Druckenmiller, the greatest living hedge fund manager in the world, use just such a technique with his investment team:
I want you guys to try and block out where fed funds are and just consider this economic data and let’s play a game. We’ve all come down from Mars. Where do you think fed funds would be if you just saw this data and didn’t know where they were?
This was back in the fourth quarter of 2003 when nominal GDP was growing 6% year-over-year, retail sales were rising 5%, inflation (headline CPI) was running just over 2% and unemployment was about 6%. Stan remembers his team responding:
I’d say of the seven people the lowest guess was 3% and the highest was 6% [versus an actual of just 1% at the time]. So, we had a great conversation that the Federal Reserve was making a mistake with way too loose monetary policy. We didn’t know how it was going to manifest itself but we were on alert that this was going to end very badly.
So let’s do the same thing today: Nominal GDP grew 12% year-over-year in the fourth quarter of 2021; retail sales rose 16.5% in December from a year earlier; additionally, inflation grew 7% year-over-year and the unemployment rate fell to 3.9% that month.
If you didn’t already know where the fed funds rate was, where would you guess it would be? Certainly, nobody in their right mind would guess it would be zero AND that the Fed would be printing money at an annualized rate of roughly 6% of GDP at the same time (as they were very recently). It’s just so far outside the realm of what is reasonable that it’s laughable.
Still, this is the world we live in. And the Fed just ended its money printing and raised the fed fund rate from zero to twenty-five basis points, as if that is any more reasonable given the context above. In truth, it’s so absurd as to be totally unbelievable to anyone who hasn’t become totally inured to absurdist monetary policy in recent years.
And this brings up the point of an exercise like this: to eliminate recency bias from the intellectual process. So much of our thinking related to the Fed and markets and everything else is colored by recent history. It’s only human nature to look at how things have behaved over the past few years and project those trends out into the future.
As Seth Godin wrote this week, “Whenever there’s a speculative bubble going on (or a cultural one, for that matter) life inside the bubble seems rational and normal.” There is a very clear cultural bubble around monetary policy and the markets today that make the extraordinary feel normal.
But this tendency leaves us vulnerable to being caught off sides when a paradigm shift arrives. Even if all of the fundamentals and technicals have changed and in an obvious way, most investors simply ignore those signals because their recent experience plays a far more significant role in their minds, conditioning them to expect more of the same rather than a shift to a new regime.
So here is another thought experiment for you: First, block out where the various financial markets are and how they got there. Again, you just landed from Mars. In the context of this economic data and given where monetary policy is in relation to it, how do you think most institutional investors would be positioned?