Stocks Firm in Anticipation of Further Fed Ease

Stocks displayed impressive resilience last week, rallying in the face of a continuing stream of bad news from the housing and mortgage finance sectors, further erosion in the U.S. dollar, and new highs in the price of oil, which closed at a record $91.86.

It is said that a market that can rally in the face of negative news has a particularly strong underlying bullish trend and is destined to move higher, but we wonder how much of last week’s strength was driven by anticipatory buying ahead of this week’s Federal Reserve meeting.

Bulls remember how much fun it was to be long in front of the last Fed meeting (and bears remember how painful it was to be short!).

Tomorrow afternoon, we get to see the extent to which the Fed is willing to go to promote inflation in its efforts to prop up the ailing housing market. The justification from the Fed for its rate-cutting is that the bear market in housing combined with the tightness in mortgage markets will lead to a slowdown in consumer spending that could push the economy into recession.

There is certainly ample cause for concern about the oversupplied, overvalued state of the housing market. Last week, the National Association of Realtors reported that September existing home sales were down 8% from August and 19% from September 2006, with inventories soaring to a 10.5 month supply.

However, it is not at all clear that the Fed, which has no direct control over the longer-term interest rates upon which mortgages are based, is helping to relieve the problems in real estate by cutting the Fed funds rate. What is clear is that the Fed is having great success in stimulating inflation in other areas of the economy. In the six weeks that have passed since the Fed last met to determine how best to manipulate the price of short-term money, the price of oil has soared 18%, gold has gained nearly 10%, and the U.S. dollar has fallen over 3%.

Despite these inflationary red flags, markets have fully priced in another quarter-point rate cut from the Fed this week. Is it conceivable that the Fed could do nothing with rates at this meeting out of deference to its inflation-fighting mandate? That is possible but unlikely. Fed officials have said nothing to disabuse markets of the expectation of a quarter point cut, and Bernanke has proved himself to be as accommodating to Wall Street as his predecessor.

Moreover, the Fed has not expressed particular concern about the melt-up in commodity prices or the slide in the dollar. It seems that until long-term interest rates rise, the Fed can promote inflation and devalue the dollar with impunity. At the other end of the rate cutting spectrum, is it possible that the Fed will deliver another 50 basis point cut in the fed funds rate? Given where oil, gold and the dollar are currently trading, a half point cut seems inconceivable, but should not be completely ruled out.

It is certainly an interesting game that is being played out. Fed policy has undeniably been successful in reviving the "animal spirits" of investors, which were badly deflated in the credit market carnage over the summer. But such animal spirits can quickly turn back to risk-aversion if the housing/credit markets mess turns out to be a more intractable problem than is currently imagined, or if inflation pressures finally translate into higher long-term bond yields.

At this point, we remain agnostic about (1) whether an expansionary monetary policy can re-stimulate credit systems and asset prices sufficiently to ward off a housing and consumer led recession and (2) when longer-term interest rates will adjust upward to appropriately reflect real inflation (i.e. currency debasement). Accordingly, we think the appropriate posture is to be conservatively invested with inflation hedges.