Larry Kudlow and Interest Rates

Larry Kudlow initiated a debate about interest rates today which Dennis Gartman defended with erred old-school logic. My points on this topic have already been made clear but I think, given the erroneous conclusions drawn by Dennis Gartman, my points should be reiterated.

The debate concerned the level of interest rates and how rising interest rates might affect the stock market. Dennis Gartman's theory was that the market can do very well in the face of rising interest rates and that it probably would, like it has in the past.

When interest rates are being adjusted to curb or influence growth in the economy interest rates and the market have a direct correlation; this has been true for the past 10 years. That means, if the FOMC were raising rates because the growth rate in the economy was too high (and they wanted to curb that growth rate) the market would increase along with levels of interest rates, and assuming the FOMC was spot on, the Market would stall and turn lower when Interest Rates peaked and turned lower too. The FOMC has been nearly perfect at leading the Market this way for the past 10 years.

However, when interest rates are being increased to thwart inflation the opposite happens. If inflation is an immediate concern and interest rates are being raised in the face of an already weak economy to combat high levels of inflation we cannot expect the stock market to increase along with interest rates. In fact, we should expect the market to decline substantially if interest rates increase substantially in the face of a weak economy. This, in no uncertain terms, is exactly what we will be faced with later this year, and it is why Dennis Gartman's theory is flawed..

Unfortunately, there is much more to worry about.

Interest rates will not start to increase until the fourth quarter of 2008. At the end of 2008 the number of adjustable rate mortgages that are set to adjust drops off dramatically.

Be sure, the FOMC will leave interest rates at extraordinarily low levels because they know if they do not leave interest rates at these levels the high number of adjustable rate mortgages that are set to adjust in 2008 will result in even more severe defaults then we are already witness to.

To save the banking industry and our financial system the FOMC must keep interest rates low until the risk stemming from those adjustable rate mortgages subsides. This will take place at the very end of 2008

At the same time we will have a new president and his name will be Barrack Obama. With our new president will come higher taxes.

Going into 2009 the economy, which will continue to be very weak, will also be faced with higher interest rates and higher taxes. Oil might not even be as important anymore, if you can believe it!

For the time being we should expect the market to trade in a sideways trading pattern until Q408. Volatility should continue to be moderately high and the market should trade back and forth continuously.

Not until the fourth quarter will market begin to weaken measurably. That, however, will definitely be a grim time for all buy and hold investors because the decline will be substantial.

In 2007 I was called the Grim Reaper because of my predictions of lower market levels in 2008. Today, my outlook is even more grim for 2009.

Comments

[Larry House:]

I couldn't agree with you more. Where or where is any fix for our economic problems in the next many months? Author Harry S. Dent is predicting a crash in 2010. I think it is closer than that. I too am very concerned about individuals who are counting on stocks to do well to fund retirement, etc. I know someone can always paint a silver lining on everything, but I sure don't see one now. Courage.

2008 Jun 10 10:54 AM

[Philly Jim:]

Dude -

The year 2009 may be grim but not for the U.S.. The BRIC fad is almost over. Check out the outflows.

2008 Jun 10 10:57 AM

[icandoitdon:]

yes, the purpose behind rate increases...cooling a hot economy vs. fighting inflation...has everything to do with market performance. this was pointed out on kudlow's show by another commentator. might have been joe b. but i don't recall...

2008 Jun 10 03:40 PM

[Archman Inv...:]

Dennis Gartman has gone from a respectable letter writer (Ok well I guess he is still respectable and a good letter writer) to a 5 day a week CNBC guest. He nightly appearances on the gambling channel's favorite gambling show, "Fast Money", have lost him big credibility with me. They must be throwing him a nice amount of money for him to put his reputation and his investing smarts on the line. I don't know, but if it was me, and I was a well known investor like him, who likes to get in ahead of the crowd, and make money ahead of the crowd, I would think he would not want to be on TV giving away all his secrets, thoughts, and trades. That's why I cannot figure out for the life of me how investors in Karen Finerman's Metropolitan Fund, want to keep their money with her. I mean shouldn't she be concentrating on her fund, not preparing for her Fast Money show every night and certainly not telling an audience what her fund is invested in or is interested in buying?

BTW, Gartman is wrong on interest rates. The Fed raising rates is NOT a problem as long as all aspects of the underlying economy are in great shape. However, housing is still a mess, households are up their eyeballs in debt and still have plenty of outstanding adjustable rate "stuff" that might get affected by rates, the 10 yr, the 30 yr, moving around. Employment numbers are weak, manufacturing is weak, and the only companies that have been truly doing well were the ones leveraged to the weak dollar.

BTW #2, Bernanke is a bold faced liar with his whole, the economy is doing fine BS.

Lets not kid ourselves. The Fed is not going to raise rates as long as housing is in bad shape and the economy is weak.

And if they do. If they find religion and realize that inflation is the stock market killer, things just don't happen over night. Inflation isn't cured in a day. The economy had really better be strong if they are going to kill inflation, because if not, well, i do not want to even say it.

2008 Jun 10 04:33 PM

[gabe borens...:]

The issue goes beyond what the market perceives as inflation. The current broad but selective price spikes are reflective of unprecedented speculation assisted by the record unidirectional bet on the commodity prices by the hedge funds and industry as well.In the real inflationary cycle ,the real estate prices would be rising at or above the implied rate of inflation.In the mean time the real estate price
have imploded. Clearly ,the commodity prices have prevented the FED from easing more aggressively ,someting that economy needs .
The rational way address the issues would be for the COMEX and the NYMEX and perhaps CBOT to raise the margins on the respective futures contracts to 100%.Within two months a massive commodity price implosion would follow allowing the FED to ease more dramatically. Either way the leverage deployed in the emerging market economies implies the major cyclical implosion causing flight to dollar assets (U.S) in the period ahead.It is deflation not inflation that is the real threat.

2008 Jun 10 09:54 PM

[icandoitdon:]

"Clearly ,the commodity prices have prevented the FED from easing more aggressively ,someting that economy needs."

i agree with all of your comments except this. cheap credit and lots of it is what created the fiasco we have today. it is responsible for the housing bubble and subsequent crash and it is responsible for much of the speculation in commodity prices occurring today. the opportunity cost of such trades are nil.

we don't need more cheap money. we need incentives for americans to save and penalties for them to borrow...namely higher interest rates. if that causes 20% of the retailers in this country to go t**s up that's ok....we'll still be over-retailed.

we do not have a stable financial system. the underpricing of risk is one of the primary reasons for it.

2008 Jun 10 10:42 PM

[adan:]

nice array of items covered

my only qualm is re: "...we will have a new president and his name will be Barrack Obama. With our new president will come higher taxes."

i don't know how accurate it is, but cnn has an article comparing mccain and obama's resultant tax rates if they should win:

money.cnn.com/2008/06/...

and unfortunately, i don't make over $603,000, so, fortunately, i won't pay more taxes

but as suzi orman would say (paraphrasing), give me the money, i'll gladly pay the taxes :-)

2008 Jun 11 01:42 PM