Follow The Fed: Doug Roberts Exclusive Interview (SPY, IWM)

Courtesy of John Nyaradi.

Follow The Fed To Investing Success: Exclusive interview with Doug Roberts, Chief Investment Strategist, Channel Capital Research

John Nyaradi: Hi everyone. I’m John Nyaradi, publisher of Wall Street Sector Selector. Today, I’m really pleased to welcome our special guest, Doug Roberts. Doug, welcome to Wall Street Sector Selector.

Doug Roberts: Thanks very much for inviting me, John.

John Nyaradi: Doug is the founder and chief investment strategist for Channel Capital Research, an independent research firm focusing on investment strategies using the Federal Reserve’s impact on stock prices. He’s the author of “Follow the Thread to Investment Success: The Effortless Strategy for Beating Wall Street” and has previously held executive positions at Morgan Stanley and Sanford Bernstein & Company. He has an MBA from the Wharton School at the University of Pennsylvania, is widely quoted in major financial media and also writes for AOL Finance. Today, we’re going to talk about the markets and investing and Doug’s outlook for 2012. Doug, let’s start with Europe.  What do you see there?

Doug Roberts: Well, Europe is again, John, really a game of kick the can down the road. They still have their underlying problems, but they seem to come up with these measures that essentially put a lid on it for a couple of months until another level of deterioration comes along. And then each time we think that, you know, in essence the Euro zone is going to fall apart because of the lack of consistency among its members and inaction by the ECB, (European Central Bank) they tend to come in at the last minute with kind of a Hail Mary pass where they at least put a temporary lid on the problem and postpone it several months later.  At which point, you know, we get another crisis popping up.

Then it’s almost like that story where somebody is actually plugging holes in a dike and hoping eventually to muddle their way through, and that seems to be the pattern and I don’t think that’s going to change for the next year.

John Nyaradi: So you see more of the same kind of thing just this up and down volatility with Europe?

Doug Roberts: Absolutely. Absolutely.

John Nyaradi: What do you think the “end game” is? You know, we hear that term a lot. Where does this thing end?

Doug Roberts: There are three alternatives that are associated with this. Number one is really restructuring. If you look at two banking crises in the ’90s, that gives you a pretty good blueprint for what the results can look like. The first one where restructuring occurred was Sweden. They nationalized the banks and made massive cuts and there was serious pain. You know, there’s no easy way out of this situation. But Sweden was able to restructure its financial system, reestablish basically a sound banking system. They’ve actually come out of this quite well.

Then we take another alternative where we keep kicking the can down the road and that is really Japan. They’ve never wanted to deal with the problem and right now, you know, they’re currently completing their second lost decade and some people are wondering if they’re going to go into a third lost decade. Finally, the third alternative is something that we had during the 1970s where in essence we had a stealth restructuring in the sense that there’s inflation and inflation is taxed. So if we look at it, you’re actually raising taxes to pay for everything and that can occur vis-à-vis people having bracket creep going into higher rate brackets just because of inflation even though they may not actually be achieving any real increase in wealth, they’re just getting an increase in taxes.

John Nyaradi: In a recent article, you see some parallels between today’s time and 2007. Can tell us what you see as the possible parallels there?

Doug Roberts: Most people don’t realize it but in 2007, the Fed did start to ease quite aggressively relative to history. However, it wasn’t quick enough to really diffuse the crisis and so you had the advent of quantitative easing. So this maybe is something similar to the European scenario that we’re talking about. They’re starting to ease, they’re starting to address things, but it’s really been vis-à-vis conversational means and it’s not really quick enough to diffuse the situation. It’s able to postpone it, but it’s not really able to diffuse it. So it’s a question of kind of coming up with enough stimulus on a monetary level to reverse any financial crises that pop up.

Now I fully believe given that we’re going into an election year and it’s also an election year in which the president is standing for reelection and so people are not going to want to go in front of voters with a crashing stock market and increasing unemployment. So they’ll probably do whatever is necessary and even if there won’t be QE 3, there might at least be QE 2 ½ and they’ll try not to make a mistake. But there is always the possibility that they may make a mistake and not do something quickly enough.

John Nyaradi: You’re really an expert on the Federal Reserve.  What’s your overall grade of the Fed?

Doug Roberts: I think the Federal Reserve really made a substantial mistake during the 1990s when  Alan Greenspan switched the focus from the discount rate to the fed funds rate. Now most people are saying, “Well how did that impact the economy, what does that even mean?” Well, in essence what the Fed did was the Fed said we’re going to now shift from bailing out banks to bailing out everyone.

By relying on federal fund money as opposed to the discount rate, this, in effect, gave money to everyone. A lot of hedge funds, brokerage firms, which every three or four years would go out of business, become insolvent because of high levels of debt suddenly now had access to money. This gave rise to what was commonly known as the Greenspan Put or the Fed Put where they said well, you know, if we get into financial problems, the Fed will always give us money and bail us out.

At that point, since they were unregulated, these firms decided to lever up. Each time a crisis occurred such as ’98 and the Fed was successful at diffusing it by injecting more money, people would basically raise the degree of leverage which led us to the problem that we had in 2007 and, by the way, we still have today. There are still similar high degrees of leverage being utilized as was demonstrated by the recent bankruptcy of MF Global. So until really they come up with fundamental restructuring to deal with this problem, it will keep persisting.

In that sense, Bernanke was stuck with basically a bad lot and what he’s tried to do is keep things stabilized. Now what he truly needs to do and it’s very difficult to do is say that all the Fed can do is really make you comfortable. And that’s really the current battle that we’re engaged in, with the Fed trying to basically pass the buck toward other branches of government and with those branches of government saying, in order to truly deal with this problem, it’s going to be unpopular and we don’t want to go in front of the electorate sponsoring unpopular measures. And that seems to be a bipartisan consensus by the way.

John Nyaradi: Talk about your book, “Follow the Fed to Investment Success.”

Doug Roberts: We find that one anomaly is the so called small cap anomaly, that small cap stocks consistently, over time, outperform the S&P 500 (SPDR S&P 500 Index) (NYSEARCA:SPY) by about 3%. But the problem is it comes in short bursts and outside of that small cap stocks (iShares Russell 2000 ETF) (NYSEARCA:IWM) tend to under perform larger stocks represented by the S&P 500 the rest of the time.

What we found is that this is related to negative real interest rates, which indicates that the Fed is pumping money. That’s a very, very simple, clear indicator and we described it in our book, and if you’re investing in those periods of time where there are negative real interest rates, that is, when short term interest rates are greater than the rate of inflation, then that’s where you get the juice from small cap (NYSESEARCA:IWM) out-performance.

In some of our additional research, we found a similar pattern also exists with gold relative to Treasury Bonds. All of gold’s out-performance relative to bonds comes during periods of time when there are negative real interest rates. You don’t really have to trade that frequently, every two to three years on average, and then as a result, you’re able to get S&P-like returns with much lower volatility. Or if you’re willing to stomach higher volatility, you can actually get better than S&P-like returns with about the same risk level that you have of being in the S&P. (NYSEARCA:SPY)

John Nyaradi: I always like to end these conversations by asking if there’s anything else you’d like to add?  Is there one thing on your mind right now that keeps you awake at night, that investors like me and you should be aware of going into the New Year?

Doug Roberts: I think we just have to realize that we are in a secular bear market that began approximately in 2000. Government is the lender and spender of last resort in that economy and we’re dependent upon that, so as the government stops spending or stimulating on a monetary level, we tend to lapse back into that bear market. People don’t really want to deal with it, but I think it’s very, very important to be aware that this is a heavily manipulated market dependent upon government action, and that without that government action, the market can suffer some severe problems.

John Nyaradi: Well, folks, we’ve been talking with Doug Roberts, Chief investment strategist for Channel Capital Research, an independent investment research firm that focuses on investment strategies using the Federal Reserve’s impact on stock prices. Doug, it has been wonderful talking with you today.

To learn more about Doug and his work, just follow the link at the end of this interview and that will take you to his website which describes his work and book in greater detail. Doug, thanks for joining us and I know we’re all looking forward to talking with you again soon.

Doug Roberts: Thanks very much, John. Have a great day.

Learn more about Doug Roberts, Channel  Capital Research and “Follow The Fed.”