Farr: How Should You Invest Now? It’s A Game of Chicken

For months investors have been speculating about when and how the Fed will begin to extricate itself from its aggressive intervention in the economy. As early as March 15, the Federal Reserve reiterated its commitment to buy $600 billion of Treasury securities through June as part of its ongoing monetary stimulus. However, several Fed governors (albeit, all long-standing hawks) have since expressed their reservations about continuing QE2 and the ultra-low interest rate policy that were keys to the stabilization of the housing market and the economy at large.

On Wednesday, Kansas City Fed President Thomas Hoenigsaid that the Fed should "move the U.S. federal funds rate off of zero and toward 1% within a fairly short period of time." He also said he believes that aggressive Fed monetary policy was partly to blame for global commodity price inflation - a sentiment that has been refuted by Fed Chairman Bernanke. "Once again, there are signs that the world is building new economic imbalances and inflationary impulses," Hoenig said. On Tuesday, St. Louis Fed President James Bullardsaid that he believed the Treasury purchases should be cut by $100 billion. Last Friday, Philadelphia Fed President Charles Plosser said the Fed should start to unwind its stimulative monetary policy in the "not-too-distant future." Each of these Fed governors, voting members or not, carries influence over the process.

Have we begun to see a tide shift?

A shift in Fed sentiment with regard to monetary stimulus is no small issue for investors. Many thoughtful economists and market strategists believe that the massive monetary and fiscal stimulus is at least somewhat responsible for the sharp and ongoing rebound in stock prices since the March, 2009 lows. I agree. As I stated in my Market Commentary two weeks ago, investors have been increasingly willing to invest in stocks because they believe the Fed will rescue them if the stuff hits the fan. This perceived downside protection (commonly referred to as "moral hazard") is precisely what caused the housing bubble. We fear that current investor complacency could be leading us down the same path.

Does Hoenig agree?

Is he simply worried about commodity price inflation or was he talking about financial asset prices when he said "the world is building new economic imbalances." It seems that he is worried about both, because he also said "if current policy remains in place, we almost certain will stimulate growth of asset values and inflation." He also said "extended periods of accommodative policies are almost inevitably followed by some combination of ballooning asset prices and increasing inflation." It appears at least this Fed governor has learned from past mistakes.

The Fed's monetary stimulus has been helped recently by several economic shocks across the world, including continued problems in Europe, the Japanese earthquake, and the turmoil in the Middle East. These issues have led to "flight-to-safety" purchases of US Treasury bonds, creating lower bond yields - the same goal as QE2. Bond investors continue to weigh the severity of these geopolitical risks against the June expiration of the Fed's QE2 program. These issues have complicated the task for the Fed. Bernanke & friends clearly fear that pulling the plug now could lead to a meaningful spike in interest rates, a downward spiral in housing, and possibly a double-dip recession. We can't disagree with those concerns. However, we also believe that the Fed must weigh the longer-term consequences of their current path as well. Is creating another yet another asset bubble the correct answer to what ails us?

The question for investors over the past year was how one should have invested through a weak economy and with significant Government intervention. However you faired, you are now faced with a new question: how does one invest as accommodation is reversed? Strong companies without much leverage, strong cash flow, and organically increasing revenues make most sense to us.

Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C.  Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.