Fed Surprise Demands a Re-Evaluation of the Markets

Includes: EGY, GS, UXG
by: Thomas Kelly

The Federal Reserve’s 50 point cuts in both the fed funds rate and the discount rate obviously took the market by great surprise yesterday, as evidenced by the wild gyrations in virtually all the financial markets after the announcement at 2.15pm. The surge in equities, with all major indices rising by more than 2 percent, appears to signal something more than simply a short squeeze on the back of the Fed rate cut.

There were certainly other signs that yesterday’s move was a bit of a watershed. The euro hit another new record against the dollar and looks poised to hit $1.40 any day now, gold hit a 28 year high above $735, and oil surged to a new record above $82 in the wake of the Fed’s decision.

All of this signals that I have to completely throw away my bearish stance toward the economy (as discussed yesterday), and completely reverse my posture to reflect the surprise news. With the Fed cutting so steeply, many of the problems for financials will be erased, and companies that had so far weathered the storm should benefit from lower rates and a reinvigorated credit market. Therefore, on the basis of the news, I have covered up my last remaining short in KFED at $13.90.

I am now inclined to go long on the market, and I also remain aware of the need to protect against the potential inflation that could result from this rate cut. With gold and oil both at a record, inflation is very real, and I’ve decided to enter new positions in these areas in an effort to protect against accelerating inflation. With regards to oil, I’ve taken a sizeable position in Vaalco Energy (NYSE:EGY) at $4.51. Vaalco boasts a very cheap valuation, a strong balance sheet, a share buyback, and some interesting exploration activities off the coast of West Africa, and I look for Vaalco to show some life on the back of this rate cut. With regard to gold, I’ve taken a more moderate position in U.S Gold Corp. (NYSE:UXG) at $6.33. I’ve written about and followed UXG for some time now, and I continue to believe it to be a very interesting exploration company that will be highly levered to rising gold prices.

I’ve also completely reversed my sentiment on the financials, and especially on the brokers. With a 50 basis point cut freeing up the blockage in the credit markets (at least temporarily), it should allow the brokers to get out of their private equity commitments without too much trouble. Therefore, in response to the cut, I’ve decided to go straight to the best of breed of the brokers, and I’ve made a large investment in Goldman Sachs (NYSE:GS) at $198.14. With Goldman’s limited exposure to the mortgage market and growing overseas business, I believe that they are poised to really benefit from this half point decrease in the fed funds rate. If Goldman is able to show minimal impact from the crisis when they report earnings on Friday, the stock could rally back above $220 by week’s end, and seems to me to be one of the easier trades to make in response to the rate cut.

Finally, although my posture has changed radically overnight, it remains perfectly possible that the rate cut will still prove to be too little to late, particularly with regards to the housing sector. Indeed, housing remains difficult to predict here. Although the pressure on the financials is likely to ease, housing appears to be more problematic due to the huge inventories that have to be burned off. I continue to doubt whether lower interest rates will do the job without a lot more pain in the sector, but it remains to be seen whether prices will stabilize as homebuilders look to get rid of inventory with huge sales a la Hovnanian last weekend. I haven’t quite made up my mind as far as the group goes here, but I will continue to watch the sector with intrigue.

Overall, I believe we have our first decent trading opportunity for longs in quite a while, and I’m looking to take advantage by buying the best of the beaten down brokers in Goldman. However, the risk of inflation also looks to have come back into the picture further, necessitating some inflation protection as well by buying gold and oil stocks. My posture is now significantly extended on the long side, although I do have a bit more powder left in case a further opportunity arises.