The Federal Reserve, the Economy, and Stocks

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Includes: DIA, QQQ, SPY
by: Jeff Miller

Sometimes a concept is so simple and compelling that one would expect it to be universally embraced. When important government agencies demonstrate a commitment to addressing a problem, investors and traders alike would be wise to take notice.

Instead, stocks have declined dramatically, actually beginning at the time the Fed engaged in cutting rates and initiating the successful TAF facility. A key point is that Wall Street guru's and pundits all seem to believe that they are better and smarter than those in government.

We try to find the real experts. There may be other blogs written by people who have extensive experience in the three relevant arenas - academia, government, and financial management -- but we have not seen any. (Readers please correct us ASAP).

The choice for the investor is easy. On the one hand, you can accept the arguments of the market pundits who think that government officials are too stupid and academics are too smart, and both are therefore out of touch. Alternatively, you might consider the possibility that some very bright and capable people choose different career paths. They are all good at what they do.

Outsmarting the TV and Internet Experts

The unending hunger for content makes everyone an expert. Yesterday the CNBC noontime anchors were swept away by a prediction of an inter-meeting rate cut by the Fed, a prediction made by a young woman who is a strategist for a firm trading fixed income instruments.

She might be correct in her call, but many of the bearish pundits have made two big mistakes:

  1. They predicted that the Fed was "in a box" and would not ease aggressively. Strike one.
  2. They next opined that the Fed must stop cutting rates because of a declining dollar and rising commodity prices, something that they accept as a better measure of "inflation." They were wrong again. Strike two.

These pundits now think that the Fed is "Pushing on a string." We hear this prediction from very few actual economists. This is pretty strange. We believe that it will be "Strike three."

Our view is that there are plenty of experts on different subjects. When we are looking for trading insight and stock-specific information, we read and consider carefully the views of Doug Kass (full disclosure -- he is a colleague on TheStreet.com). His ideas are plentiful, profitable, and worth the price of admission. He endorses the "string" theory.

When it comes to economics, we prefer the viewpoint of David Malpass, who has had a multi-year record at reading the economic twists and turns with great accuracy. Last week he weighed in on this topic in a report for Bear Stearns (NYSE:BSC) investors, Massive Fed Power--How it Works.

Fed Not Pushing on a String
We think there’s a general underestimate of the power of central banks to stimulate their economies in the short term.
• U.S. recessions have occurred when the Fed tried to stop inflation with high interest rates (1974, 1980, 1982, 1990), a situation the Fed may put off until 2009 or 2010. In contrast, when the Fed has held interest rates down to the inflation rate or below, the result has been strong growth, as in 1977 and 2003.

Malpass goes on to explain how the effects are amplified by the Hong Kong Monetary authority, how circumstances have improved since the August credit problems, and why the economy is likely to expand. He does not believe that it will "end badly."

The compelling argument is that the Fed is determined to avoid a deflationary spiral. If you are an investor, that is something to keep in mind.

Will this result in some future inflation? It depends upon the reaction of the economy and the pace of the Fed in reversing the rate cuts. While no one knows for sure how this will play out, it is not a firm basis for investors and traders looking to the remainder of 2008. That story is one of economic expansion, including both the Fed and fiscal stimulus.

Some Analysis of Rate Cutting

Michael Zhuang at The Investment Scientist has a nice table summarizing stock returns after periods of Fed rate-cutting. His familiar conclusion is the quote from Marty Zweig, "Don't Fight the Fed." Readers should check out his article for the full story.

We believe that the analysis actually understates the case. The current environment is even more bullish since we are starting from such a high level of negativity. Actual corporate earnings outside of financials remain strong. The financial stock earnings include write-downs that emphasize current FAS 157 accounting, marking to illiquid markets, rather than looking at future potential. It is something to consider.

Conclusion

Market averages are heavily influenced by technical trading, forced liquidations, and sentiment. As we indicated, there is a sense that January lows must survive a re-test. We are not anticipating a good employment number on Friday, a subject for tomorrow.

We do not indulge in short-term market calls. On somewhat longer basis, the averages are still trading at the level when our Gong Model (report available upon request) indicated a good risk/reward for those with a multi-month horizon.

We are also very confident that a solution for monoline insurer problems will be forthcoming. The market skepticism on this subject has been vastly overdone. This is an important development for financial stocks, particularly Merrill Lynch (MER).

Full Disclosure: We are long MER.