Bad decisions eventually end badly

By DAVID MOON, Moon Capital Management, LLC
June 30, 2013

When the University of Tennessee hired Lane Kiffin as its football coach, any reasonable person knew that his tenure would end badly. There was an expectation of a bunch of football prosperity before the program would eventually pay the price for his methods, but the end probably wasn’t going to be very pretty.

And the longer Kiffin and Ed Orgeron stuck around, the larger the mess would be for the next guy to fix.

Quantitative easing is the Lane Kiffin of economics. Everyone knows that a program in which a single investor uses leverage to buy almost all of the newly issued long-term government debt could only eventually end badly.

While Lane Kiffin stayed in Knoxville only 13 months, the Fed’s massive bond manipulation program is now in its 55th month.

On June 19 Federal Reserve Board chair Ben Bernanke announced that the Fed plans to scale back its bond purchases later this year. Any reasonable person knew this day was coming – and how investors would react.

When markets reach or approach new highs, investors can be unjustifiably optimistic. When investors receive bad news – even if everyone knows it’s coming – the reverse occurs. There has been no change in the underlying economic fundamentals in our country that justify the recent decline in stock and bond prices.

But there is no justifiable reason that the Fed would continue its interest rate manipulation program permanently, either.

In the short-term, the price of an investment will move in reaction to almost anything, whether rational or not. A lot of that has occurred with certain investments as interest rates declined. People bought investments simply because the returns offered on their preferred asset class had fallen to almost zero. The value of some businesses that were paying high dividends hadn’t actually increased, but their popularity did.

As rates increase, the opposite will happen, or is happening.

One difficulty is knowing whether this is the actual increase in rates that reasonable people expect, or if it is simply a head fake. As an old mentor of mine used to say, “is we is or is we ain’t?”

Being from Alabama, this made perfect sense to me.

I don’t know if we is right now or not, but I do know that we eventually will.

What should an investor do?

Unless you move to cash when the overall market declines there is little you can do to avoid falling prices. And if you move to cash, you can’t know when to move back into stocks – usually not until after the market increases.

Higher interest rates will hurt businesses that depend on regularly borrowing money for operating or capital needs. Other businesses can benefit from higher earnings spreads when rates increase.

Identifying the difference isn’t easy, but generally companies that borrow money are hurt by higher rates. Companies that loan money can benefit from them.

Companies that do both are more difficult to assess.

We may be about to discover what sort of mess Bernanke leaves in his wake. I wonder if Southern Cal needs an economist?

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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