Fight the Fed: This Could Be the Most Profitable Trade for the Next 3 Years

This is a guest post from Matthew McCracken, a Texas-based Registered Investment Adviser (RIA) and founder of McCracken and Company.

Nearly every time I strayed from the herd, I made a lot of money.
-- Jim Rogers

If you run with the herd, you have a much higher risk of being trampled.
-- Warren Buffett

In 2000, it was easy to understand what the 'herd' was betting on -- technology and the dot.com boom.

In 2007, it was rising home prices.

Today, the herd has hopped on the 'Don't Fight the Fed' bandwagon. The consensus among investors is that the Fed is both willing and able to save the U.S. economy and stock market from anything bad.

In an interview with Yahoo!Breakout titled 'Market Sell-Off? Nope, Bernanke Will Save the Day,' Burt White, Chief Investment Officer of LPL Financial, said:

'Bernanke and his weaker dollar strategy are gong to save the day. Further abuse of the greenback will support our multinationals, leading to higher stocks and more jobs. As long as Ben and crew can create 'good inflation' [asset inflation] but avoid 'bad inflation' [price inflation], companies will be hiring and consumers will be ready to shop.'

When asked 'Does Bernanke have this much control of what he likes and what he doesn't like?' White responded:

'I think so. You know the axiom, 'Don't Fight the Fed.' I think that is the single sole thing. Other than 'Buy low and sell high' it's 'Don't Fight the Fed.' If anyone has the power, it's the Fed and we are not going to fight it.'

The Almighty Fed?

Not many on Wall Street would disagree with Burt. But ai data certainly does, and I do, too. So does legendary investor Jim Rogers, who has explicitly advised investors 'to short Ben Bernanke.'

In the past 10 years, there is considerable antidotal evidence that the Fed is far from omnipotent. In fact, they seem to be growing more impotent by the day. There are three specific examples:

1) Gold Prices: Since 2001, gold prices are up six-fold. In fact, gold is the only security I'm aware of that has appreciated each of the past 10 calendar years.

Of course, the Fed hates gold because it is its main competitor. In recent testimony before Congress, Bernanke went so far as to say that gold is not money. In this futile attempt to discredit the yellow metal, Bernanke certainly overlooked 6,000 years of history.

If the Fed was omnipotent, gold would not be appreciating in any significant way, much less be the best performing asset class of the past decade.

2) Inability to Prevent the Financial Crisis of 2008: Bernanke and friends have received a lot of credit for resolving the financial crisis of 2008. However, news is coming out daily of the extreme measures they took leading up to the collapse of Lehman and AI.

Ultimately, the Fed couldn't keep it together, and it was only after a $1 trillion taxpayer funded bailout that the stock market found some footing (now the total bailout exceeds $5.3 trillion). Even with these unprecedented measures, hundreds of banks and the world's largest insurance company collapsed.

3) Residential Real Estate Prices: The Fed has thrown everything but the proverbial kitchen sink at the housing market -- and prices are still hitting new lows. Home prices refuse to rise even after the Fed bought a ton of worthless mortgages, backed over 90% of current loans and committed to maintaining negative interest rates in perpetuity.

There is nothing more the Fed can do for housing and housing prices are still falling. If the Fed is so powerful, how can this be?

The Fed is certainly one of the most powerful economic forces on earth. When they meet this week, I'm certain stock prices across the globe will rally on whatever pitiful new program they come up with to 'stabilize the economy and create economic stimulus while containing inflation.'

But the Fed is not above economic law. And one of the most well established yet least understood economic laws is simply that 'you cannot borrow or print your way to prosperity.' The Fed is certainly not the first and will definitely not be the last central bank to attempt it. They also will not be the first or the last to fail at it.

Building Your 'Short Fed Fund'

So if the Fed can engineer one more rally out of the stock market this week, it might be a great time to start building your 'Short Fed Fund.'

You could start with the obvious ways:

• Go long precious metals
• Short U.S. Treasuries
• Short the U.S. dollar (USD) through currency pairs

A slightly more potent means of shorting the Fed would be to bet against specific sectors they are trying to distort, like:

• The housing market. Short it through housing stocks like KB Home (NYSE: KBH), Toll Brothers (NYSE: TOL) & DR Horton (NYSE: DHI)
  
• The bond market. Short it through bond insurers such as Assured Guaranty (NYSE: AGO), Genworth Financial (NYSE: GNW), MGIC Investment (NYSE: MTG) and MBIA (NYSE: MBI)
  
• To-big-to-fail banks. Short it through large banks like Goldman Sachs (NYSE: GS), JP Morgan Chase (NYSE: JPM), Morgan Stanley (NYSE: MS) and Citigroup (NYSE: C)

Of all these options, I prefer shorting the banks. And here's why.

Take a bank like Bank of America (NYSE: BAC) or Morgan Stanley. The Fed is allowing them to borrow money at 0% interest. They can take this capital and invest it in the foreign debt of countries like Australia and Brazil who pay 5-7%. Then they can leverage up their investment 30:1 and hedge the currency risk through the FOREX markets.

However, they are doing this relative risk-free and dummy-proof trade and yet they still can't make money! What happens if it actually costs them money to borrow? If the Fed is forced to raise interest rates, any bank that is currently unprofitable is likely gone.

My Favorite Way to Fight the Fed

Life insurance companies, like Prudential (NYSE: PRU), Lincoln National (NYSE: LNC) and Metlife (NYSE: MET) offer the best of all worlds when it comes to shorting the Fed. It is one of those rare, 'heads I win, tails you lose,' kind of trades.

Life insurance companies have the same ill-advised exposure on their books as the banks, including worthless mortgages and overrated muni-bonds. They also own a boat-load of interest rate sensitive securities -- so if rates go up, their portfolios are wrecked.

But unlike banks, life insurance firms cannot borrow from the Fed if things get really bad. During the last financial crisis, the Fed bailed out AIG's debtholders, but the stockholders were wiped out. (One reason why Jim Rogers has often suggested, 'If you're going to buy something stupid, at least buy the debt and not the equity.')

And here's the kicker. Many years ago, life insurance companies quit being life insurance companies. They are now financial services firms that sell investment products. Of course, they can't compete with the likes of Wall Street firms, so they created a plethora of insured products to sell -- products that provide protections against a market downturn.

But as we learned in 2008, no one can properly insure against a systemic event (i.e. an event that impacts everyone the same). So if the stock market falls, they will never be able to make good on all their guarantees -- which will make them insolvent.

So for my money, I'm shorting the Fed with tickers like PRU, LNC, MET and Hartford Financial Services Group (NYSE: HIG).

Disclosure -- The author is short various securities mentioned in this article. In the month prior to the printing of this article, his portfolios have been short PRU, LNC, MET, GS, BAC and AGO. At the time of this article's posting, his firm may or may not continue to maintain these positions and may or may not add to these positions in the coming months.