Investors Get a Glimpse of the Future

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 |  Includes: DIA, QQQ, SPY
by: Jeff Miller

Yesterday's trading provided a rare opportunity -- a look into the future. The Fed action, as we expected, showed determination to fight recession prospects in an aggressive fashion. The FOMC is attentive both to the current economy and to financial disruptions that could spiral into negative economic effects.

While many traders were poised to bet against a rally from a 50 bp cut, they were quite wrong -- for a while. The market was rallying strongly based not only on the move, but the statement. It is clear that the Fed is attentive and ready for more action if needed. The market rallied strongly and our opinion is that it was poised to go much higher, breaking through technical resistance levels.

That is the important view into the future.

What Happened?

The first thing to understand is that much of the punditry has been wrong about the Fed. The media has been focused upon the question of whether the Fed was "duped" or "fooled" by the unwinding of bad trades at SocGen (SCGLY.PK). We analyzed this and there is plenty of evidence that our view was correct. The Fed is acting in accordance with principles developed by Chairman Bernanke and explained by a colleague in this article. In a conference call to Bear Stearns investors, David Malpass cited the same Mishkin speech we did in our article. The Fed move and statement confirm the reasoning.

The Fed is concerned about disruptions in financial markets and a possible downward spiral that translates markets into economic effects. Briefly put, they are on the case.

The market decline was sparked by a downgrade of FGIC. We highlighted the importance of this concern, noting the stock market rally when a successful plan seemed to be imminent. Lower ratings for bond insurers threaten the asset value of securities held by many firms. Announcements about further downgrades have moved overnight futures even lower, suggesting a weak market opening tomorrow.

What Will Happen?

We expect a solution to this problem simply because there is so much at stake for the counter parties of the bond insurers. The solution is difficult because the financial institutions involved need to agree both upon the design of the plan (investments or a reinsurance pool) and how much each might invest. Yesterday's Wall Street Journal featured an excellent article on the issues.

Federal officials are not yet involved in a bailout plan, so attention is focused on New York Insurance Commissioner Eric Dinallo, now advised by Perella Weinberg Partners. Seeking outside advice makes sense, because a talented insurance commissioner may not have the right skill set for putting together a bailout plan.

Some have confidence in Dinallo and he is well aware of the urgency.

To emphasize, we expect a successful bailout plan because the amount at stake for financial institutions is much greater than the cost of investing in the plan. They will get it done, but the market will be nervous as the story unwinds.

Conclusion

The issues involved in counter-party risk are so great that the market reacts to any whiff of negative news. Bids are pulled, and stocks sell off rapidly.

When there is a resolution to the issues related to bond insurers, investors and traders alike will move back to a focus on economic prospects, future earnings, and Fed policy.

Yesterday's trading gave us a look into the future about the market reaction to these fundamental factors. Those who believe, as we do, that there will be a resolution to the bond insurance problem will see current market levels as an opportunity to buy.

It is so easy to see the problems, and so difficult to see the solutions.