The Federal Reserve, the Economy, and Stocks

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 (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.

Comments

[Balsamo]

First let me say that i admire most of your work.

However, i have some doubts about your latest theory that says "Don't believe the bloggers, trust the experts who are adressing the problems, etc".

So you want us to believe in the Fed, in the government.
But who put us in this mess in the first place ? weren't they experts ? financial engineers ?
Who permits the credit bubble to developp in the first place ? Some bloggers or Allan Greenspan ?
Just wondering.

By the way, as you quote "U.S. recessions have occurred when the Fed tried to stop inflation with high interest rates (1974, 1980, 1982, 1990), "...
That may be right, but as far as the markets are concerned : 1974 saw a nice relief rally that brought the SPX to over 100 (from 60) by 1977. and 1982 is the beginning of the greatest bull market of history.

What i see at this point is that those experts at the Fed or at the government ( the same one that couldn't see the problems coming!) are now underestimating the danger of inflation...only to adresss some short term economic issues...disregarding the real danger longer term : inflation !

Maybe people like George Soros, Jim Rogers or Mark Faber and many others are some non-experts bloggers...they saw all the problems we're in coming a long time ago...So lets forget what they are telling us now and trust Bernanke...

[robster]

While your career experience makes you more informed than most and the work you put into your blogs is very good i just, for the life of me, cannot see the rose tinted outlook that you give. While i also bow to the eminent economists you quote the facts are these: you have a deep housing recession, gdp down to 0.6% and probably falling because we see the ism indices, durable goods orders and payrolls in contractual mode. Inflation is sticky with productivity down and oil at 100+. On top there is tight credit and a hugely geared cdo market based on those housing assets. Where is the growth coming from? Is 2008 really a year of economic expansion?I'm not saying there will be armageddon but the facts are there. The last quarter may save its bacon but its no stellar year in store.

[NoFate]

It's called a business cycle Jeff ...get over it.

We are in a confirmed Bear market ...until we confirm a new Bull market we will be in a Bear market and we should act accordingly.

Finally, there are many relevant blogs out there ...the Big Picture, CR , Mish, Roubini, etc. Their arguments are usually MUCH stronger than "the Fed is working on it" or "the Fed said so", so no worries!

[Let Us HavePeace]

The ratio of the 5 Yr. vs. 30 Yr. Treasury yield has been a robust indicator, and it confirms Mr. Miller's optimism about future returns on present U.S. equity investments. The last time the ratio was at its present value was in mid-September 2002, which was certainly a better than average time to make actual investments in the U.S. stock market (that is, to buy a decent quality company's stock and keep it for the next 2 to 3 years). Adjusted for the Federal Reserve's Major Currency Index, the S&P 500 is up only 22% from its March 2003 value - which was the low for the last 10 years. Since its "bull" market high last May, the adjusted index has fallen almost 24%; it is now back to the level of May 2005. That would, by most reasonable standards, constitute a bear market. As the other comments confirm, very few people want the long side of the trade right now. That is itself a confirmation that we are in the range where hindsight will tell us that stocks were cheap in March 2008.

[gordon]

The GDP is a fraud because it's imput inflation figure(deflater) is a fraud, underestimated by at least 2%. Thus the GDP is negative, and probably has been for 2 quarters. The BLS will lie about 2 negative Qs in a row, just as the employment report will again be goosed not to show 2 negative months in a row. Last time the revised 2 prior months to make sure it wasn't 2 losses in a row. This Friday they probably revise Jan to positive, watch.

[NoFate]

Let Us Have Peace - SOLD TO YOU!

There are NO technical indications that we are at a bottom ...and using treasury yield ratios is pretty friggin arcane if you ask me. You might use that kind of information as a part of your analysis, but are you really willing to hang your entire thesis on that??

And sometimes when more people are bearish than usual it just means stocks are going down further. When people were bullish for 5 years it didn't mean we were peaking did it?

Guys - There are HUGE problems out there ...maybe the Fed will save the day, but we essentially still have the same set of problems we did 6-9 months ago ...except they have just gotten far worse. Nothing has been fixed at all. Why should I have faith that things aren't gonna get alot worse before they get better?

[NI123]

I have said it many times in the past, and I feel compelled to say it again: Basing an investing thesis on market sentiment alone is not a sound investment strategy. I see that Peace has cited the 5 to 30 yr Treasury yield ratio as well... And as far as I can tell, that is about all the bulls have going for them. Face it fellas, liquidity is drying up, residential housing is dropping like a rock, commercial is not far behind, the consumer is clamming up, commodity prices are soaring, and earnings guidance is being adjusted downward across the board. Hell, even muni auctions are ending early due to a lack of buyers. We are already at .6% growth, and the FED is finding itself unable to reflate the economy. We WILL see negative growth this year - The only question is how long it will last. My take is that it will indeed be a recession, but will probably only last a couple of quarters. 2009 will be when things get tricky as inflation gets out of hand. Until then, gold and oil will outperform the market by a significant margin. Yes, that's right - $1k/$100 is not the top, not by a long shot.

[Growin $$]

Until someone tells me how the CDO issue (the trigger of this,if you please) is resolved, not by the Fed,or the Fed Gov't., or by any magic wand, rather by a step-by-step exposition of the REAL steps it will take to unwind a mortgage default on 123 Main St. USA that sits in the CDO portfolio of a cash-squeezed financial institution at 789 never-never land, Wall St. USA or a bankrupt bank/financial institution at ein-zwei-drei Das-Strasse, EU, I will have a hard time agreeing with anyone's forecast or crystal ball. Absolutely no one has yet dealt with that hard, fundamental issue - the core issue recognized implicitly last August. Write-offs, insurance company bail-outs are tangential problems whose solution or partial solution doesn't truly solve the core cause.
The detailed exposition of a solution that will be implemented, however painful or onerous its impacts, will be the first step in a long road to establishing the accepted valuations whose current absence is destroying peoples' ability to trust anyone who is called "financial" or borrower. The inability or failure to see how to do this rather specific act is assiduously sabotaging all the other efforts, to date, because none of the the so-called incremental solutions deal with the fundamental issue of unwinding the originating trade.
Since all of the above analyses, up-down-and sideways, goldilocks & apocalypse, fail to provide this, I do not believe they can be tested for validity as they have not illustrated a process on which their or anyone's potentially positive vision must be based. Growin$$