A Top Secret Investment Opportunity: Don't Fight the Fed!

How the world has changed! Marty Zweig's 1986 book, Winning on Wall Street, gained a lot of popularity after he famously called the market crash of 1987. One of the most noted Zweig precepts was the following: Don't Fight the Fed!

What has changed?

The Challenge

Fed policy under Bernanke has a new challenge. The seizure in the credit markets has created a situation where the Fed Open Market Committee sees a challenge that has several different dimensions. From their perspective, the problem is not just one of adding liquidity. The Fed is attempting to address two specific additional concerns:

1. The elevated LIBOR rate -- something that affects Adjustable Rate Mortgages, swaps, and many business loans. LIBOR, a rate little understood by equity traders, reflects the interest charged by non-US banks holding dollar deposits. It is elevated because the banks are unsure of the counter party exposure to structured investment vehicles that include mortgage securities. The lack of transparency in other bank's holdings makes short-term lending problematic. Why reach for a little yield, when there is a risk of bank failure? When LIBOR was adopted in many agreements, it reflected a reasonable risk premium to Treasury Bills. That was the usefulness - something better than the prime rate. The agreements did not contemplate a situation like the current one.
2. Banks holding mortgage investments on their balance sheets may have difficulty in using these as collateral for additional lending. This limits their ability to do future lending, an important consideration. The discount window accepts these assets as collateral, but the rate is higher and there is still a stigma attached to this approach.

The Fed Reaction

The Fed chose this week to target the specific problem rather than to cut fed funds by 50 bp's instead of 25 bp's. Was this wise?

As we noted in our reaction to the Fed policy, the proposed auction process, the Term Auction Facility [TAF] is explicitly targeted to the perceived problems. We see the Fed as completely engaged in the process of reducing LIBOR and creating a market for mortgage holdings.

Earth to traders! The concept of not fighting the Fed has a new dimension. Get with it, or lose.

The Fed succeeded only marginally with its effort at expanding borrowing through the discount window. It is trying something else. If it works, they will do more of it. If it does not, they will try something else.

The Market Reaction

We are struggling to recall a reaction to a new policy that was more negative. Partly because of the market decline on the day of the Fed announcement, and partly because of the timing of the new policy initiative, nearly everyone is negative.

Leading market pundits of both bullish and bearish persuasions condemn the Fed. Some are unhappy that the markets were misled. Some think the policy will be ineffective. Traders must remember that each day is a new one. Complaints about the sloppy Fed timing of announcements have little bearing on future prospects.

In his excellent blog, Harvard Economist Greg Mankiw highlights the bad press for the Fed. He notes, as we did last week, the divergence of opinion between professional economists and everyone else.

Our Perspective

When so many people have the same reaction, and we think it is incorrect, it provides an unusual opportunity. Leading critics think that the Fed members are not as intelligent as they are, that they are all academics and therefore out of touch, that they are "behind the curve", that another 25 bp's of fed funds would have made the difference, and that the Fed should include trucking company executives and fund managers (to pick at random two recent comments). More on these criticisms in future articles.

The criticisms often point to the lack of reaction in current LIBOR rates (using many incorrect time periods and many irrelevant expirations), while declaring the Fed's innovative TAF as dead on arrival. Anyone thinking this through should realize that the impact on LIBOR cannot be expected to happen until the auctions take place. We shall see this week.

Conclusion

We acknowledged that the timing of the Fed announcements lacked sensitivity to market reactions. The "false signals" were neither planned nor expected. Those who do not understand government agencies tend to impute motives that were not really there. They think that organizations behave like a unitary actors -- with a clear, rational plan in mind.

The simple explanation is that the Fed is doing multiple things, with various other cooperating agencies, on different schedules with different announcement timetables. One of the advantages for our readers is that we have the only approach (we think) that describes for readers the actual policy-making process.

Could the Fed have done better? Sure. But the process of transparency in policy announcements is new, and still developing. Meanwhile, the question for investors is what to do now. We take the approach that no one is stupid. We look for the best information from all sources.

We do not know whether the TAF will be successful, and neither does the Fed. They are attempting something innovative that might work. If it does, you will soon see many articles in mainstream publications that will get around to explaining what economists and our readers already know. It could be a solid market catalyst, and that is our position going into this week.

For readers with futures accounts, we have bought a few Jan 08 Eurodollar contracts. This is an interest rate instrument based upon LIBOR that should rally if the TAF is successful. For those who do not trade futures, a perceived success in the auctions should also help equities.

A Final Thought

We are astounded by one-sided review of the Fed -- in the mainstream media, in blogs, and on financial television. Those who act as the gatekeepers for such information - the sources we admire and regularly cite -- have not highlighted any of those who defend the Fed. Any investor who believes in a contrarian approach should find this an interesting opportunity.

Comments

[Aquater]

Rather than explain the explanations in great detail I'd rather see more ink on exactly what are the implications for different investement classes.

[Yossel]

Many thanks for a calm, quiet, rational, balanced and illuminating analysis of the circus!

[seven24]

Well thought out--The reason we seldom hear a rational explaination by the talking heads is because analysis requires an explaniation time frame greater than the alloted thirty seconds before the next commercials.

[granger]

I actually dug out my old Zweig book and notes on Thursday. Gave my self a quick review adn reaffirmed my thoughts.

This is the most bullish I have been in over 5 years. We received a cut that we probably should not have. I am glad they only did .25 (wish they would have held or raised from an economic perspective, tbut the market reaction would have been violent).

There are many positive for equites. I want my money invested where it will outpace inflation, equities fit the bill. I learned along time ago, 3 cuts and the markets will be higher in the coming years.

I am good to go. Rounded out all of my positions as the market has pulled back since the last Fed deicision. As of Friday's close I am as close to 100% offense, as I will ever be.

[Walter Mundell]

Very good aproach. Congratulations.

[Pangaea]

"Don't 'fight' the Fed"

Um, what about the charts that show the stock market and the Fed funds rate usually move in the same direction?

At least for a good long while anyway...

After all, the Fed raises because the economy is strong, and the Fed cuts because the economy is weak, right?

So why is selling equities with a weak economy "fighting the Fed"? Would buying stocks with a strong economy (and RISING rates) also be "fighting the Fed"? Just look at recent history, late 90's and 2002-2007...

Just would like to see a little actual data or analysis instead of a hackneyed chestnut.

[NoFate]

>> Earth to traders! The concept of not fighting the Fed has a new dimension. Get with it, or lose.

Earth to Jeff ...the Fed is stuck between a recession and stagflation at the moment ...and whatever cuts they make will help us in 2009.

Further, their auction will not help. It is a drop in the ocean of bank debt and the banks still don't trust each other due to a lack of transparency.

The Fed is trying to look like they are doing something so they don't get blamed for the mess.

And get with the program ...recessions happen. If the Fed shortens the one that is nearly upon us they will have done their job.

Finally, don't fight the Fed means don't leave yourself exposed in the market when the Fed announces rate changes ...it is common sense. It does not mean take some Pollyanna position that the Fed is going to drop out of the sky like Superman and save the world.

[Pangaea]

A different sort of piece on SeekingAlpha:


The Great Fed Rate Cutting Myth: Look Out Below

seekingalpha.com/artic...

[Mr. Denny]

Being new, the LIBOR defined, would be what, exactly? Thank you for the education.
Howard Denny