Bullish Reflexivity
Famous speculator, George Soros, has coined the term “reflexivity” to describe financial markets. Reflexivity is what makes traditional financial and economic theories so inadequate for any predictions in the real world. Reflexivity is not complicated—it basically means that actions of investors impact the market which then impacts the investors’ actions again, resulting in a loop that can get out of control. The Fed has taken advantage of positive reflexive loops as it powered the markets through a phenomenal bull run. For example, the Fed lends free money to investors; corporations then borrow cheap debt and finance stock buybacks. Stock buybacks inflate stock prices and reduce the apparent leverage of the corporation, because equity is now worth more and debt-to-equity is lower. Lower debt-to-equity allows investors to borrow more funds and repeat the cycle again. There have been dozens of such bullish reflexive loops during the past five years.

Bearish Loops And Deflation
The Fed cannot hike rates because it will break the positive reflexive loops, while setting in motion a number of negative ones. The Fed’s stated goal is to get inflation above 2 percent. Recently the Fed suggested that the risk of a hard landing in emerging markets is also a consideration. Let’s try to imagine what would happen when the Fed hikes rates. The flow of funds to all kinds of positive feedback loops will be slowed or stopped. Investors will sell some risky assets. This will create significant deleveraging worldwide, because investors will value holding cash more than they do today. It is not surprising that China is begging the Fed to delay the rate hike; Chinese officials know what will happen to their markets. This deleveraging will create significant deflationary effects and CPI inflation will be even lower than it is now. To be fair, inflation is actually quite high for many items from rent to tuition and healthcare, but that’s another issue. For now let’s focus on the CPI as the definition of inflation, because that is what the Fed watches. The inflation will go closer to zero or even negative forcing the Fed to abandon its remaining credibility and quickly drop rates again. So, the Fed cannot hike or, if it does, will have to quickly backtrack because inflation will be even further from its goal and a Chinese hard landing will ensue. But the hike has been promised so often and the Fed can’t figure out how to undo all those promises.

Volatility Will Be On The Rise
This loss of credibility by the Fed is creating a uniquely risky environment where most market participants are lacking direction. This uncertainty means in a crisis event, liquidity may be nonexistent. As a result, I believe that many tactical managers used by advisors will not be able to get out of the way of risk, even if they did in 2008.

Your Response To The Fed’s Actions?
So, how should you think about the Fed’s actions in the context of managing and protecting your clients’ money? I put that question to Mark Hooker, who for many years led State Street’s Advanced Research Center with a team of 30 PhDs and now manages Infusion Global, an SMA money manager. Here is his reply:

I think the Greenspan put, which evolved into the Bernanke and now Yellen puts, is overrated—markets still fell roughly 50 percent after the tech bubble and again in the Global Financial Crisis, and about 15 percent peak to trough in 2011. Undoubtedly, the Fed’s support has made equity returns better than they would have been (largely through making yields on fixed income assets less attractive), but timing investments based on views of monetary policy action is a narrow and very difficult approach. Markets have been expecting rate hikes for years now but translating that into positive active returns has been challenging even for global macro managers who are experts.

And there you have it. You cannot ignore the Fed, but in making long-term decisions you should assume that market forces will prevail (and they certainly will).

With A Little Help From My Friends
No I get by with a little help from my friends
Mm I get high with a little help from my friends
Mm gonna try with a little help from my friends
—The Beatles, Sgt. Pepper’s Lonely Hearts Club Band