Bernanke Blinks - And Suffers Credibility Hit

As the cost of money went down Tuesday, so did the credibility of Ben Bernanke.

Since when did John Kerry become Fed chairman? Talk about flip flops. How do you go from being an advocate of the market discipline and exude confidence in holding the line against bailouts and then do exactly the opposite in less than 2 weeks!?!?

Frankly, I am less stunned by the ½ point Fed Funds rate cut and more so with the unanimous vote that supported it. Accordingly, I am sensing that this is not Bernanke’s Fed. The dynamics of the Fed board bear studying and the minutes of yesterday's meeting will be most illuminating re Bernanke’s leadership skills (release next month). Until then, upcoming economic and earnings data points will shed light on just where the US (not the global) economy stands. For now, a useful exercise would be to consider what the rate cut means to valuation models, which is where all economic matters must lead investors to.

From a valuation perspective, what yesterday’s Fed action implies is that we have taken a step back toward the PE (private equity) valuation model. And in doing so, has put back in play (to some degree) the takeover premium and hot money game that the global liquidity drainage action of the past year was slowly taking away. Therefore, valuation metrics and earnings expectations for 2008 must now come into view.

Once again, the simple, elegant yet very effective modified Fed model that I use (see update table above - click on image to enlarge) provides a guide to possible scenarios. It is the yellow zone of the table that I wish to draw your attention to. Specifically, the prospects that a $96 S&P operating earnings number is a reasonable earnings expectations for the next 12 months. If rates rise (thanks to concerns of rising global inflation), then the enlarged yellow box implies a high single digit return for US equities from current levels.

This, of course, assumes that the credibility damage created by yesterday’s Fed action does not produce unintended consequences. And in a highly uncertain world, unintended consequences should always be assumed.

Investment Strategy Implications

With the strong rally and the expected rise in longer term rates, the valuation gap to full value has and will continue to close. Accordingly, the recent 100% invested position expressed in my Model Growth Portfolio (see performance data in left column) will be reduced at the next re-balancing (Monday). Until then, the trade recommendation made nearly two weeks ago (buy Homebuilders – XHB) has achieved its target and is hereby removed. Other changes are forthcoming.

Comments

[StreetSweeper:]

Ooops, your political leanings are showing. It's not that John Kerry has become Ben Bernenke, it's more that Ben Bernenke has become a George Bush. Either he was forced to make the cut or he is inept. In either case, the dollar weakens more, U.S. esteem suffers, inflation looms in the future, and the buck stops with him and his decision.

2007 Sep 20 03:48 PM

[Vinny Catalano:]

I agree with your comments re the US dollar, US esteem, and inflation, StreetSweeper.

Re my political leanings, wrong guess.

2007 Sep 30 11:44 AM