In the study of various sciences such as physics, biology, or even economics, we often create models to help us better understand the world around us. These models often start out simple and usually only account for a few variables at a time. For example, when solving a physics problem, we may assume that friction doesn’t influence the movement of an object. That may be an okay assumption if you were calculating the movement of an ice skater along the ice, but ignoring friction could have a devastating impact when discussing vehicle safety or sending a spaceship to the moon. So too is the case with investments. As investors, we often create models to try and explain the economic world around us. For example, to explain the price of a stock or asset class, we may look to the future earnings power and discount rates to calculate a fair value. But too often these models fail. Just as many came to believe in the efficient market hypothesis theory, the 2008 financial crisis proved to be a wake-up call that the world of sociology and investor behavior is more complicated than even the most sophisticated models of today.
Since the failure of many traditional valuation models, many investors have shifted from a bottom-up-only view of the world to one that incorporates a more top-down approach. Thanks in part to massive amounts of liquidity in the form of Quantitative Easing, Fed-watching has become a main source of the new top-down approach. Unfortunately, leadership at the Federal Reserve remains in question and a seat change may be afoot again. During an interview on June 18 with Charlie Rose, President Obama stated, “He’s [Ben Bernanke] already stayed a lot longer than he wanted, or he was supposed to.” The statement was a clear signal that new leadership will begin February 1 of next year.
Over the past month, the search for a new Fed Chairman has narrowed to an apparently short list of two candidates: Larry Summers and the current Vice Chairman of the Federal Reserve, Janet Yellen. While many influential members of the economic community were quick to vocally support Yellen, the pendulum of consensus now appears to be forming around Larry Summers. In fact, the nomination has garnered so much momentum in the financial community, that Paddy Power, a United Kingdom-based gambling site, is taking wagers on the outcome. The current odds are fascinating, with Larry Summers a 1:2 favorite over Janet Yellen, with 2:1 (against) odds. Amazingly, as charted by Zero Hedge, in less than a month’s time, Summers has moved from having an outside chance to being the favorite. If you’re skeptical of foreign-based online gambling websites, even reputable sources such as Bloomberg put the odds of a Summers nomination at 60%.
What does this mean for investors? Whereas the investing community largely expects a Yellen nomination to represent a continuation of the current monetary policy as directed under Chairman Bernanke, a Summers nomination is far more uncertain. However, I’ll quote from one of our trusted research providers, 13D Research:
We have read everything that Summers has written in recent years and we suspect his views coincide very closely with that of President Obama. What makes this all so interesting is that Summers is a vocal supporter of fiscal expansion. It is highly possible that if he is nominated and confirmed by the Senate that he will push for a form of Overt Monetary Finance…Today’s Financial Times carries an article on Summers that quoted remarks he made about the effectiveness of quantitative easing at a conference last April. “QE in my view is less efficacious for the real economy than most people suppose…If QE won’t have a large effect on demand, it will not have a large effect on inflation either.” Summers also gave a highly optimistic outlook for the U.S. economy. “I think the market is underestimating the pace at which the Fed will alter its current course and the consequences of that for interest rates.” This means a radical change in the markets’ expectations. The article also emphasized the following: “People who have discussed policy with him say Mr. Summers regards fiscal policy as a more effective tool than monetary policy.” What has been lacking at the Fed is a strong personality and intellectual leadership. Summers is brash, intelligent and self-confident, traits which may enable him to take charge of the FOMC. A regime change of this order of magnitude would be a game changer of the highest order, impacting inflation, economic growth, wages, gold, and the U.S. dollar….
The jury is still out as to who will ultimately be the next Fed Chairman and what their policies will be. Similarly, given that Summers represents a shift away from the status quo, his recent surge in garnering the nomination may partially be why markets have decided to take a breather. After all, markets prefer predictability and quantitative easing has been a major tailwind for investor confidence. Thus, we wouldn’t be surprised to see higher market volatility as investors adjust their models and conceptual frameworks to reflect the possibility of a new Federal Reserve paradigm led by Larry Summers.