The Fed's 'Bizarro' World

NEW YORK ( TheStreet) -- The Seinfeld TV comedy series had an episode titled "The Bizarro Jerry" in which everything "normal" was turned upside down and inside out. The Federal Reserve seems to have accomplished something similar with its experimental Quantitative Easing (QE) policies.

For the first time in a long time, underlying economic fundamentals are turning positive. Ordinarily, this would be good news for investors. But in today's upside-down, topsy-turvy, bizarre markets, "good" news is bad for investors. The blame for this is squarely on the Fed's QE policies and similar policies adopted by other central bank mimes.

The Good News

In the labor markets, job openings continue to be hard to fill (JOLTS report), layoffs and firings are at levels not seen since 2007 (Initial Jobless Claims, week of Aug. 10), and Voluntary Quits ("Take This Job and Shove It") are rising.

The consumer appears to be holding up (retail sales), and deleveraging appears to be on its last legs (rising credit card and auto debt). Europe looks like it has bottomed (positive second-quarter GDP growth), and the news from China shows higher growth levels than penciled in by the pundits.

Normally, such news would be accompanied by rising equity prices, but not this time. In the U.S., the U.K., Europe, and Japan, recent positive economic data has been met with equity market selloffs. On Aug 15, the Dow Jones Industrial Average sold off 218 points despite five-year lows in jobless claims, a continuation of positive retail sales trends, and high and rising homebuilder confidence, a good leading indicator of future home sales.

The table shows the performance of the world's equity markets with activist central banks for the year until the Fed's "tapering" announcement on May 22, and then from May 22 to Aug 15. Note that until May 22, the markets with activist central banks performed quite well despite relatively stagnant economies, but after the "tapering" announcement, equity prices have been less than stellar. Normally, during the first signs of a change in policy toward tightening, what we find is both rising interest rates and rising stock prices because monetary policy tightening means a strengthening economy.

The Bizarro World

David Patterson of Brandywine Trust Group, in an Aug. 15 piece in the The Wall Street Journal, opined that markets no longer move on fundamental economic data, but on anticipated Fed policy moves. In fact, it isn't so much the policy change itself that moves the markets, but whether or not that change was more or less than anticipated (i.e., the second derivative).

Patterson's premise is that the market knows that the Fed is counting on the "wealth effect," via a rise in equity prices, to have an impact on consumption, and anticipates and discounts Fed actions to achieve that "wealth effect." If the Fed acts (or fails to act), and its actions (or lack thereof) disappoint market expectations, equity prices react negatively. As a result, because "good" fundamental economic data means a stronger economy and less need for monetary accommodation, we now have the bizarre world where "bad" fundamental economic news moves the markets higher, while "good" news does the opposite. That is, "bad" is now "good," and "good" is "bad." Patterson sums up the Fed's Bizarro World as follows:
"The process can at some point turn powerfully negative, if the monetary stimulus stops, or is expected to stop, or becomes ineffective, which it will if it is expected to become ineffective, because it is only effective based on what the market expects."

There are no special attributes of wisdom that are automatically imparted to the Fed's chair at his/her swearing-in ceremony. The nontraditional policies adopted by the Bernanke Fed, and mimicked by other major central banks, are experimental.

Going in, they did not know what the unintended consequences would be. But now we are getting a glimpse. At this writing, we do not know how the Fed's September decision about the "tapering" of its QE program will impact the equity markets. Will it disappoint, or not? But, what we do know is that in the Fed's new bizarro world, whatever that decision may be, and whether it disappoints market expectations, market reaction will not be tied to economic reality.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Robert Barone is a partner, economist and portfolio manager at Universal Value Advisors, an investment advisory firm in Reno, NV.

He previously held positions as an economist for Cleveland Trust Company and as professor of finance at the University of Nevada. During his tenure at Comstock Bancorp in 1996 he became a Director of the Federal Home Loan Bank of San Francisco, serving as its Chair in 2004.

Barone also served as Director of AAA of Northern California, Nevada and Utah and a Director of its associated insurance company. He currently serves on AAA's Finance and Investment Committee. Along with his son Joshua, he founded Adagio Trust Company in 2000. Barone received a Ph.D. in Economics from Georgetown University.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.