Making sound investment decisions requires an understanding of what is going on.  Unless you are using a mechanical model, you need an intellectual framework for interpreting news events.

Many sources offer help.  There are scores of interpreters of the daily market action, but most of them are on a mission.  Whether the objective is political, gaining ratings, or demonstrating wisdom, my experience is that 90% of it is completely wrong.

Yesterday is a good example.  The market sold off sharply, the biggest loss in many weeks.  The selling came shortly after the FOMC decision was announced.  Post hoc, ergo propter hoc. There is an overwhelming temptation to link these two events.

As a preface, here is an interesting comparison.  Each night I record via TIVO and later watch Kudlow and the PBS NewsHour.  This prepares my investing decisions and sometimes provides the basis for these reports.  The perspectives from these two programs, as you might expect, are quite different!  PBS leads with Palestine and the UN.  The Fed is not mentioned in the first twenty minutes of the show.  My guess is that a few months from now we will all agree with the PBS emphasis.

With this background in mind, let us return to the obsessive market coverage.

Possible Explanations

Readers of “A Dash” have been challenged with some past problems concerning causal inference, and they have done very well!  Today’s little test should be easy.  Here are the candidates:

1. The Fed consists of a group of clueless bozos (TM pending — OldProf) who will inevitably do whatever is wrong.  Everyone else is smarter, better-informed, and has superior analytical skills.  This especially includes journalists, hedge fund managers, anyone who is interviewed on TV, and anyone with a blog.
2. The Fed policy, Operating Twist, disappointed the markets leading to the selling.
3. The Fed frightened markets by stating that economic conditions had weakened since the last meeting.
4. The three dissenters.  This shows that (choose one):  The Fed is adrift, there is impending stagflation, Bernanke will lose his consensus.
5. There was other news that bothered market participants — the Moody’s downgrade of some banks or news from early corporate earnings reports.  Those wishing to sell on this news waited until after the Fed announcement, just in case there was a surprise of some sort.
6. Short sellers had covered positions last week in front of the Fed meeting.  Traders have a fixation on the potential of QE-style moves, so they wanted to be flat until they knew what would happen.
7. When selling started in the final hour, some piled on and bids dried up.  The precise cause did not matter.  The short-term trend was clear.

There are plenty of options!  Make your own choice before reading on ——-

My Take

As a background for this section I want to point out that my preview for the week said that nothing magical would come from the Fed.  Our trading posture was bearish for the week.  I manage several programs with different time frames.  In the long-term programs I do not believe that investors should be jumping in and out of stocks, trying to time the market.  There is a different mind set for the long-term investor.  You have to believe that the market will often be irrational, offering you good opportunities.

This explains why I was concerned about this week, while still believing that the market is over-reacting to the downside.

Let me review the candidates.

1. The Fed bashing is the single biggest threat to the individual investor.  The critics do not understand the issues and would look foolish if they had to make a presentation in an actual Fed meeting.  They seem OK on TV or their blogs because they have no opposition.  There is a concerted effort to make people feel that our country has no effective leadership.  As I have frequently made clear, I am happy to have a strong leader from either party.  We should all hope for economic improvement before the next election, and expect our elected leaders to cooperate.  I also note that Bernanke is a Republican, and would be pursuing the same policies if the 2008 election had been different.  Do not allow people with an overt political agenda to distort your investment decisions!
2. The actual Fed policy decision was widely anticipated.  If anything, it was a bit more market-friendly than expected since it did more in the 20-30 year range and also addressed housing.  It is difficult to see how the actual decision could be a market disappointment, although that will be the deceptive headline story in your morning paper.
3. The Fed scared the markets?  Really?  This argument is advanced mostly by the same people who sell fear on a daily basis.  Let us try for some objectivity.  The FOMC adjusts the outlook every six weeks.  In between these meetings we see the Beige Book.  Everyone paying attention knows that economic data has gotten a touch weaker.  In the business, this is what we quaintly call “old news.”  Some will seize upon this for the familiar “Fed is behind the curve” refrain, but the update is actually timely.
4. The Fed dissenters disagree both on inflation concerns and on the underlying economic strength.  At least one of the three has stated support for more aggressive measures if the economy weakens.  Put another way, the interpretation of dissent differs sharply from what most pundits are saying.
5. I give some credence to the effect of the Moody’s story.  The effect on financial stocks, both those downgraded and others, was clear throughout the day.
6. Short sellers waiting for the news.  Now we’re talking!  The trading and short-selling community harbors an exaggerated fear about the QE policies.  Last week’s rally seemed strange and had a short-covering flavor.  It is not surprising that those choosing to take short positions would wait until after the FOMC decision to act.
7. This also makes sense to me.  When the story is complicated, most average investors will have no clue about how to react.  Bids dry up.  Programs take hold.

Investment Conclusion

At some point we will look back on yesterday’s trading as an especially interesting example of the climate of fear that defines 2011.  There was nothing really surprising or important from the Fed.  The market reaction should not be attributed to the Fed.

I especially like the careful interpretation from TheStreet.com’s market reporter Chao Deng.  Her market interpretations are better than those of the pack and well worth reading.

Although the central bank refrained from additional quantitative easing and launched a “twist” as expected, investors were surprised by the Fed’s wording that the economic outlook faced “significant downside risks,” a slight change from its last statement that said that “downside risks” had increased. Some analysts say that the tweak in language was in part behind today’s disappointing reaction

I also like the story highlighted by Barry Ritholtz, one of our favorite and featured sources. You need to read the whole story, which refutes a widespread notion that bank profitability is reduced by this move.  Quite the opposite!

I also urge readers to watch this video from Dick Bove.  Instead of just shooting from the hip, he cites solid numbers relating to bank stocks.  He discusses cash on hand, risk, European risk, capital ratios, and other key metrics.  This is much, much better than what you usually see about amorphous risks.  Bove especially addresses the Moody’s opinion that the US is less likely to support major US banks.  If you listen to him with an open mind, and then read the Moody’s report, you will be better prepared to make a solid investment decision in banks.  As regular readers know I like the best-of-breed JP Morgan Chase (JPM) despite recent declines in price.

This post originally appeared at A Dash of Insight and is reproduced with permission.