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What If The Federal Reserve Is Right?

This article is more than 9 years old.

The Fed’s July Monetary Policy Report is so benign that it could have been written by Monsignor Fulton J. Sheen for one of his 1950’s television broadcasts. Strangely, I agree with the Fed’s sense of our becalmed economic setting and how it unfolds in 2015, ‘16.

It’s as if I carry a busload of the Fed’s economists at my beck ‘n’ call. Economists call the “nothing changes much” the naïve forecast, because it rarely pans out. This may be one of the rare times it's on the money.

To summarize the Open Market Committee:  Economic growth picks up through 2016 with inflation moving up near 2%. Unemployment remains sticky longer run at 5% to 6%. The appropriate timing of policy firming? Sometime next year but gradually.

What caught my eye was expectations for GDP running at 2%, intermediate term or below normalized growth for the country. If this “feel” pans out, long term Treasuries could outperform equities, but the price-earnings ratio for the market holds at mid-teens, maybe inching higher.

Nobody sees Fed Funds above 2.5% yearend, 2016. This is nearly 200 basis points below trendline for the entire postwar financial history of the country. To me, it suggests prime home mortgage rates near 4.5% and plenty of “deal” money flowing to corporations and activists, bullish for Wall Street and stock prices. LBO's during the eighties probably accounted for 20% of the market’s levitation. In this scenario, personal wealth grows 5% to 10% per annum and homebuilding finally snaps back from its present funk.

This scenario challenges the Open Market Committee members on their 2% GDP growth rate forecast. I'm at 3%, still a touch below long term normalcy.

Lemme go on. Fed economists show some degree of humility, judging by the uncertainty of projections comparable with the norms of the past 20 years. (Their record was dismally off-based.) Some participants see more risk to the downside for their somber projections on GDP momentum and inflation.

Let’s hope these bears are more right than wrong, but I don't think so. Absent recession, below average GDP momentum and low interest rates and inflation serve as a tonic for stock market valuation. Unless the market escalates closer to 20 times forward 12 months earnings, it's playable. Everything’s on the come.

I don't see a new Internet bubble forming for large capitalization tech houses like Google, Apple, Microsoft and Cisco. Only Google sells at a moderate premium to the market, but how many big cap stocks do you know whose revenues grow north of 25%? Maybe Amazon, but it carries a skimpy bottom line.

The Fed, sensitive to missing the implications of the buildup in aggregate private non-financial debt pre-meltdown 2008, points out the present pace of increase is moderate. Everyone's focused on this indicator. Aside from perceived overvaluation in social media and biotechnology, they see no bubbles forming, except the leveraged loan category and high yield paper rated B or lower.

They are on the money regarding B rated junk and below as a risky asset category with stretched valuation on pretax earnings coverage. I’d prefer they not single out the Internet and biotech. Yes, the small and mid-cap properties are rich, but leave my Biogen Idec and Gilead Sciences alone.

Both sell at a below Google multiple of 2015's projections. There's an enormous valuation spread between Facebook and Twitter selling in the clouds. FB carries a reasonable valuation of 2015's enterprise value. Go Facebook! The Fed should resist indulging in such petty punditry.

Thank the Fed for underscoring the banking sector’s strong capital and liquidity construct. Banks and brokerage houses like Bank of America, JPMorgan Chase, Morgan Stanley and Citigroup get my money. I'm betting the economy firms quicker than the Fed’s timetable, and the yield curve steepens well before 2016, probably 2015. We'll see. If wrong, I'll sit and wait.

Nobody sees hedge funds, insurance underwriters and REITs increasing leveraged returns. Don't expect margin requirements to move up before the Fed’s sense of asset overvaluation escalates to an alarming level. God Bless. Please don't take away my punchbowl. Implied volatility as calculated from options prices has declined to low levels last recorded mid-nineties.

Our lady maximum leader also points out long-term sovereign yields have moved down. The consensus, internationally, is that inflation there remains quiescent and GDP momentum subpar. So the developed world in all hemispheres faces a slow growth scenario next couple of years.

Maybe yes, maybe no. My pivotal indicators are corporate capital spending and industry capacity utilization. Both remain flattish, good for keeping wage escalation in check. The minute I see upward movement in these two elements, I'll sell my bonds, buy more financials and pare down high multiple properties on the basis that the market is vulnerable to shedding at least 1 or 2 price-earnings ratio multiplier points.

As long as operating margins hang in, the market is hardly vulnerable. Biggest surprise in corporate earnings reports to date is rising operating margins for major industrials and tech houses like Intel, IBM and Honeywell International.

My final read on the Fed’s term paper is it's too muted for what's likely to happen, namely reaccelerating growth for the country.

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Sosnoff owns personally and / or Atalanta Sosnoff Capital, LLC owns for clients the following investments cited in this commentary:  Google, Apple, Microsoft, Biogen Idec, Gilead Sciences, Facebook, Bank of America, JPMorgan Chase, Morgan Stanley, Citigroup and Honeywell International.

Follow Martin Sosnoff on Facebook.