This week, investors watched the semiannual ritual of Federal Reserve Chairman Ben Bernanke presenting his monetary policy testimony to both houses of Congress.
There were no surprises as Bernanke talked about the importance of central bank independence, meaning he would like to maintain the ability to exercise his power free from Congressional interference.
In what seems to have become a standard part of the testimony, Bernanke warned both houses that they need to rein in spending, citing the danger of “unsustainable” budget deficits.
When it came to the economy, he was as vague as he usually is. Bernanke pointed to “notable improvements” but conceded that financial markets “remain stressed,” and downplayed the risk of inflation.
The stock market was relatively unimpressed by the testimony, registering only small changes on both days that the Fed chairman appeared before Congress and on CNBC.
A recent study by Jason Goepfert of Sentimentrader.com found that on the day before the Fed chair testifies, the S&P 500 has been up nearly 70 percent of the time. But on the day when he begins his appearance, stocks have been higher only 44 percent of the time. The study covered the past 12 years.
The most remarkable finding of Goepfert’s study may be that after traders had a chance to review the testimony, they usually sell. The market has been down 72 percent of the time on the day after the chairman speaks.
In the month following the testimony, Goepfert found that the market tends to reverse the previous trend. This bodes poorly for bulls since the S&P 500 reached a new bull market high as Bernanke was speaking.
As investors evaluate Bernanke’s comments, they should strongly consider his assurance that the Fed has a plan to decrease money supply and avoid inflation.
In his words, “We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.”
So, even though they failed to spot the crisis before it developed, Bernanke is now sure they can prevent any negative consequences from the unprecedented increase in money supply that followed the delayed recognition of economic troubles.
In reacting to the Fed chairman, markets are being consistent with their reaction to political dabbling in markets. Several years ago, Michael F. Ferguson and Hugh Douglas Witte published a paper called, “Congress and the Stock Market.”
They found that stock returns are lower and volatility is higher when Congress is in session. An interesting finding was that over 90 percent of the capital gains earned by an investor in the Dow Jones Industrial Average have come on days when Congress is out of session.
These studies seem to support the idea that markets do their best when left to function without political interference. Traders are unlikely to believe that the Fed has a viable exit strategy. But the fact that the chairman chose to announce they do means that the Fed has a plan to take action.
And action is not always the best option when it comes to the markets. At times, Fed action has made the economy worse. The same with Congress. There have been occasions where new laws had unintended consequences and hurt the economy, or at least specific sectors of the economy.
With a virtual pledge from Bernanke to be more active as the economy tries to recover and Congress doing it all can to drastically expand the role of government, investors may want to consider hedging their risks for the long-term.
Investments that do well in high-inflation, declining-dollar environments should be part of every portfolio.
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