Farr: Crying Wolf May Make Markets Complacent

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Aggressive monetary and fiscal policies have forced so much money into the economy; it has become impossible to determine how much of our modest economic growth is organic and how much may be the result of the trillions of dollars of government injections.

During periods of inflation, stock prices appear cheap because investors become less willing to pay great premiums for earnings. The idea is that if earnings are increasing because the company is selling more goods and services and generating greater profits, investors will pay more.

But, if the bottom line is increasing just because inventories can be priced higher (due to inflation) and no real gains have occurred, investors will pay less. This is why price-to-earnings multiples are lower during periods of higher inflation. In other words, investors of all stripes require some degree of confidence with regard to the outlook for future levels of inflation. (Read More: Mad Dash for Inflation-Linked Bonds .)

The conundrum in recent years is that there is little evidence of inflation despite an inflationary supply of dollars created by the Fed and profligate spending by the federal government. Moreover, long-term interest rates suggest expectations for inflation remain relatively low far out into the future. Perhaps even most surprising is the insatiable investor demand for U.S. Treasuries despite a clear worsening of our country's credit profile. (Read More: In Picking Lew, Obama Turns a Page at Treasury .)

Economists Carmen Reinhart and Ken Rogoff have written that this phenomenon is not new and, in fact, has occurred many times over the past few hundred years to several different economies. Long periods when nations are able to issue very low-cost debt extend beyond experts' ability to rationalize the continuing low rates until there is a sudden "bang moment" when rates surge higher.

While rates remain low and debt creation remains robust, the fundamental calculations of value that Benjamin Graham preached become harder to judge. It feels like a doctor whose experience assures him that cancer is present, but he can't find it on the scan. He's certain it will show itself but can't figure how bad or benign it may be when it does.

Pimco managing director Bill Gross wrote, "Zero-bound interest rates, QE maneuvering, and 'essentially costless' check writing destroy financial business models and stunt investment decisions which offer increasingly lower ROIs and ROEs."


At the beach, there is an over-tanned, chain-smoking mother of three small children who either ignores or screams at her children. When the relative seashore calm is pierced by her screeching bellows, all of the nearby sunbathers startle and turn—all except for her children, who have become oblivious to her decibels and din. So the dear lady frantically increases volume, hoping for their response, to no avail.

If a Reinhart and Rogoff "bang moment" is indeed approaching, it will likely catch markets abundantly complacent and desensitized.

Greece and the "fiscal cliff" are examples of crises that the media have beaten deader than the deadest horse. Do you remember when these topics held your attention and didn't evoke a groan? It is tempting to hope that these colossal events will matter inversely to their repetition. It is logical to believe that things that haven't seemed to matter probably won't. It is seductive to want everything to be "fine." (Read More: Farr: Welcome to the Fiscal Farce! )

The most dangerous thing about ignoring the plaintive pessimist is that he is, from time to time, correct. Government did not cure the fiscal cliff. It wrought a political solution to take politically appetizing actions and eschew all of the less appetizing. Unfortunately these not-taken, deficit-reducing steps have been delayed, but deficit spending has not diminished.

"Could the government default briefly in March? Yes. Could a government shutdown occur when the continuing spending resolution expires on March 27? Unlikely, but you can't rule it out," my friend Greg Valliere said. "Could lawmakers fail to reach an agreement in late February on the spending sequester? Of course. The markets will just have to live with this—dysfunction is the norm here; that's not going to change."

(Read More: Morici: Self-Inflicted Wounds Threaten Jobs.)

When the issues are momentous and dysfunction is the norm, how does one best invest?

Advising Clients

A new client, fearful of the fiscal cliff, told us he had sold most of his stocks in late November. He allowed that it had cost him some capital gains taxes and a few performance points of upside, but he assured us that he had been sleeping better.

One of the toughest client counseling problems is when the client's projected living needs (even at a bare minimum) argue for more risk than may be comfortable or appropriate. Determining the most prudent investment strategy always involves a certain amount of art. Each of our portfolios is managed individually, but we strongly advocate the most prudent strategy. Getting in or getting out of markets over short term periods is not something we believe can be successful over any longer period. Benjamin Graham said that a key element to successful investing was the patience necessary to allow the perceived value to prove itself.

The Next Decade

Today, investors who follow Benjamin Graham's discipline must adopt a longer investment horizon which includes an inherent faith that Corporate America will continue to expand and succeed. We are among the believers, but Fed intervention and congressional gamesmanship continue to justify our cautious and defensive approach.

As our crystal ball gathers dust (yes, we have one), we choose to invest in stocks based on a couple of very basic premises.

We do not believe the world will end. We believe that democracy and capitalism will survive in the United States. We believe that the world population will continue to grow and that productivity and innovation will yield unimaginable benefits and prosperity. We expect economic growth to recover. We expect that while share prices will be volatile through many short-term periods, successively higher valuations will be seen over time. Finally, there will always be risk.

Navigating the next few months and years through an unpredictable maelstrom, we look to invest in companies that boast solid balance sheets, strong earnings, and diverse revenue streams. We intend to hold those shares for as long as practicable.

Michael K. Farr is President and majority owner of Farr, Miller & Washington, LLC. He is Chairman of the Investment Committee and is responsible for overseeing the day to day activities of the firm. Prior to starting FM&W, he was a Principal with Alex Brown & Sons.

Mr. Farr is a paid Contributor for CNBC television and has appeared on numerous broadcasts and has been quoted in global publications. He is a member of the Economic Club of Washington, DC, National Association for Business Economics, The World Presidents' Organization, and The Washington Association of Money Managers. He is the author of "A Million Is Not Enough," and "The Arrogance Cycle."