This is not a good Fed. They aren’t making decisions on a predictive, forward-looking basis. They are very concerned about optics, appearances—how things look. And to them, right now the optics of having Fed funds at 0.375% with unemployment at 5% are very bad.

But that isn’t how it’s supposed to work. The Fed has a few hundred PhD economists who are supposed to be doing the heavy mental lifting, trying to predict what is going to happen in the future. And the future doesn’t look so good. The data is weakening, not strengthening. And yet here we are, talking about rate hikes.

There are other considerations.

The first is politics. Everyone at the Fed down to the janitor has spent the last few months denying any political influence in monetary policy decisions, which means that, of course, there is political influence in monetary policy decisions. If the rate hike comes in the first FOMC meeting after the election, in December—it won’t be a coincidence.

But there’s more to it than that. We are beginning to learn that the Fed (much like the Bank of Canada) takes fiscal policy into account when making monetary policy decisions. And fiscal policy, up until this point, has not been all that stimulative. But it will be, soon.

The bad news is that either Trump or Clinton will become president. Bad if you’re a deficit scold, like me. Clinton wants to raise taxes and spend the money on free stuff (like college tuition and infrastructure). Trump wants to cut taxes and spend even more (on a wall, and infrastructure, and the military).

Either way, we are staring down the barrel of quite a bit of fiscal “stimulus.”

A few Fed speakers have hinted that they are taking this into account in their forecasts (you can read more details here). To the extent that you think government spending causes economic growth (a tenuous relationship, for sure), the central bank should respond by keeping monetary policy tighter than it ordinarily would. Which means that the Fed is more likely to hike rates right after the election. Maybe because of politics, but also because of projected fiscal policy.

When I mention rate hikes to people, they are very dismissive. The Federal Reserve has disappointed many investors who were betting on rate hikes for many years. It is a classic boy-who-cried-wolf scenario. Of course, I have been saying since the SIC conference that a rate hike was imminent, so we shall see.

The 10^th Man, Doing His Thing

So if you ask people about the election, they generally give you two possible outcomes.

Outcome 1 (most likely):

Clinton becomes president
Republicans may or may not keep the Senate
Republicans do keep the House

Or…

Outcome 2 (also likely):

Trump becomes president
Republicans may or may not keep the Senate
Republicans do keep the House

At The 10^th Man, it is my duty to disagree. Just for the sake of disagreeing.

What if this happens…

Outcome 3:

Clinton becomes president
Democrats take the Senate
Democrats take the House

Nobody is thinking of that possibility.

Lots of people think that if Trump wins, the market tanks. Probably not. People have been thinking about that possibility for over a year; it isn’t news.

Outcome 3 is where the market’s weak spot is. If it’s a Democratic sweep, the market will be down 10-15% in a matter of days, and the VIX will find the 30 handle in no time.

I’m not saying Outcome 3 is going to happen. It’s definitely the least likely scenario. But it’s the scenario that people (and the markets) are least prepared for. Which means, as an investor, that is where the asymmetric payoff lies.

If you are good at math, you can estimate the probability of a Democratic sweep, then go in the option markets and compare it to what is being priced in. This is the sort of thing I do all the time (it’s not priced in).

Magic Beans

I’ve been around long enough to see investing fads come and go. I’m going to be that guy—that solitary codger who yells at those daggone kids to get off his lawn and wonders where he left his soup.

In this writer’s opinion, smart beta strategies are a fad. Smart beta is the idea that you can construct an index based on some arbitrary criteria that will outperform a traditional market cap-weighted index. In this sense, people think they are capturing alpha, but I don’t think that word means what they think it means. Probably what it means is that you can back-test something but not forward-test it.

Funnily enough, all the big ETF launches this year have been for miscellaneous smart beta strategies.

There is this temptation in the finance business that you can create some kind of magic pill or potion, or magic beans that you can plant in the ground and grow the money tree. If only I had a formula, or an algorithm, or a system, or a silver bullet that would make money all the time in every market environment.

Doesn’t work that way. The market exhibits what is known as “nonstationarity”—it is a game whose rules constantly change.

People seem to be pretty happy with these smart beta ETFs right now, and I’m glad they’re happy, but very likely these indices were built to outperform in one set of market conditions, and one set only. We are already seeing cracks in the low-vol ETFs.

Go take the magic beans someplace else—we’re all stocked up here.

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