Big investors pay thousands of dollars for Danielle DiMartino Booth's research. The former Fed advisor explains how the central bank has distorted markets — and shares 2 areas where analytical traders can still find returns.

  • Danielle DiMartino Booth, CEO and chief strategist at Quill Intelligence, is an advisor to former Dallas Fed President Richard Fisher and the author of "Fed Up: An Insider's Take on Why the Federal Reserve is Bad for America."
  • The Fed insider believes that the central bank has distorted the markets and made much of fundamental analysis irrelevant by pushing so many investors into passive investing. 
  • She also shared the remaining two asset classes where analytical traders can still generate returns by doing their research and two key indicators she is watching closely.
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The Federal Reserve's impact on markets is so massive today that Danielle DiMartino Booth — a longstanding critic of the US central bank — is concurring with the old Wall Street adage: don't fight the Fed.

But the agreement comes with a caveat.

"I agree with people who say don't fight the Fed until the Fed takes us on a bridge too far," said DiMartino Booth, chief executive at Quill Intelligence, a research firm that is widely subscribed among institutional investors. 

As detailed in her book "Fed Up: An Insider's Take on Why the Federal Reserve is Bad for America," DiMartino Booth, who had begun her career at Credit Suisse, served as the eyes and ears on Wall Street for Richard Fisher while he was the president and CEO of the Dallas Fed. 

Fed's massive impact on investing

A true Fed insider, DiMartino Booth believes that the central bank has had a "massive impact on investing" by pushing so many investors into passive index funds over the years.

"All you need to do is to have your 401k invested on your behalf into a target-date fund that pours into index funds that are predicated on not finding the best but the biggest companies," she said in an interview. "And they continue to get bigger regardless of what their financials are."

The trend then turns into a feedback loop, according to DiMartino Booth.

"The more you put into an index fund, the bigger the biggest companies get," she said. "And the more people whose perceptions are don't fight the Fed, the more that perception is validated."

By pumping money into the markets and pushing investors to passive investing, the Fed has also "marginalized" fundamental analysis, which refers to the analysis of various macroeconomic and microeconomic factors surrounding an asset to arrive at its fair intrinsic value.

"Fundamentals have very little place in a market that is swung 400 points one way or another based on whether the government is going to pass stimulus spending to give people an extra $400 to $600 a week to not work," said DiMartino Booth.

She added: "You've got a record number of companies that have market capitalizations of more than $25 billion that don't have any profits and that compares to just a handful at the peak of the financial crisis. And investors are giving more credence to companies that don't generate profit than they have at any time in US history."

Two key indicators to watch

In order to gauge the real conditions of the market and economy, DiMartino Booth is watching two key indicators. 

One is the Merrill Lynch Option Volatility Estimate (MOVE) index, which is the sister index to the Cboe VIX index and measures the fear sentiment in the bond market.

"Where you are going to see disruption that is easier to see is going to be in credit," she said. "And that's why we have indeed continued to see bankruptcies increase even as the Fed pumps record amounts of liquidity into the financial system."

She explained: "As long as bond market volatility stays contained, then that's going to indicate the market has maintained its confidence and the Fed will keep this rally going. But if you see bond market volatility starts to fall out of bed and to rise appreciably, that will definitely be a telltale sign."

Another set of indicators that DiMartino Booth follows closely is weekly jobless claims and the Bloomberg Consumer Comfort index, which tracks consumer views on the US economy.

"The number of people losing their jobs is relevant obviously," she said. "But if you start to see white-collar professional layoffs, that matters even more economically because they consume so much more and therefore drive so much more in the way of economic output."

Commercial real estate and precious metals 

Despite the Fed's overarching influence on the markets, there are still areas where investors can "fight the Fed" and gain price discovery. 

"The important thing for investors to understand today is that there are pockets within the financial system that the Fed can't or won't reach such as commercial real estate," she said. "And I think precious metals are going to continue to be a safe bet in the coming years."

If investors don't trust the market at its current valuations, there is nothing wrong with sitting on cash, she added.

"When you hear people like Howard Marks and other luminaries who've been investing legends for decades now that they're sitting on record levels of cash. That's telling you something," she said. "Sometimes emulating the smartest people in the room is not necessarily the worst thing when they're not going to let their clients' investments lose all their value."

But her biggest advice for young investors is to wrench control from their 401(k) plans and make them self-directed. 

"Make sure that your 401(k) plan is self-directed so that if you want to continue to save money for retirement but have to sit on the sidelines until some of this crazy expected volatility comes and goes," she said. "Then you should be able to have that optionality because it is the money that you are earning and should not necessarily be put on autopilot."

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