Don't Fight the Fed? Why Not?

by: Alan Brochstein, CFA

There’s an old saying on Wall Street: “Don’t Fight the Fed.” I have heard it often, especially when I was in the bond business. I have always thought that it reflected the inverse correlation between asset prices and the direction of Federal Reserve policy (tighter money means lower stocks and bonds, easy money means higher stocks and bonds). I am not sure, though, of the genesis of this adage, so I Googled it (9600 references) and found a reference to Marty Zweig having coined the term. Maybe this was something that made sense at some time (wouldn’t it be nice if it were that easy?), but the truism simply isn’t true.

The Fed tightened for two years beginning in June, 2004 and stocks rallied. Previously, the Fed began lowering rates in early 2001, but the stocks bottomed two years later (some lag). The Fed was tightening for two years prior to the peak of the bubble. Interestingly as well, if you take a look at the shaded areas in the chart below, you will find that the Fed began easing BEFORE the last two recessions and had to ease a very long time after to jump-start the stalling economy:

fed 1

Why do I bring this up? While I haven’t heard the four words uttered yet, the basic concept of “In the Fed We Trust” is already being discussed after the signal that Bernanke belatedly flashed Friday morning (on options expiration day!). While the market enjoyed a reflexive rally off of very oversold levels, the showing was rather unimpressive. Yes, some shorts took some very nice profits, but nothing changed. In fact, the Fed not only looks way behind the curve and reactionary, but this move is the precedent to what we are about to soon discover: The emperor has no clothes.

I have converted from a bull looking for a correction to an extreme bear. I haven’t felt this way since 1999 and am normally prone to be bullish. I have highlighted many of my concerns recently regarding the initiation of Bernanke, the potential downside in store for investment banks, the lame “rally” two weeks ago and the developing “pile of stool”. I even shared three stocks that I felt were very vulnerable in the “coming pullback” in late June. March was a shake-out, but this is something much, much more. To summarize what I have shared: We are in a global credit crunch, and the risks of recession have increased dramatically. Today, I would like to expand further some of the concepts I have discussed. Specifically, what are the links to a global slowdown, why will the Industrial sector get hit, and why are we very likely to go into a consumer-led recession?

First, though, back to the Fed: They are between a rock and a hard place. First, we are due for a recession or at least a pause in economic growth. Oh, I know, the economic cycles have been eliminated/muted with JIT inventory, but it’s simply not possible to have consistent uninterrupted growth economic growth indefinitely. If you start with the premise that the economy can’t be controlled by the government, it makes accepting the impotence of the Fed easier. By impotence, I mean that we are in a global economy where the U.S. and, hence, the Fed, are not the powers that they once were. We have one of the slower economies now. Our currency has been slowly depreciating despite having higher interest rates than our European and Japanese peers. Lowering short-term rates is likely to exacerbate the weakness in the dollar. Is it not surprising, then, to see the Yen cruise to a 52-week high vs. the dollar last week? The bigger issue, however, is that lower rates don’t cure bad credit practices. There is no interest rate that will make a bank want to lend more money than a house’s appraisal (which is the current issue for many borrowers looking to refinance). There is no interest rate that will make the value of CDOs, etc. go up. No, it will take time. And what will happen during that time?

Getting back to the three areas I wanted to touch upon, the first thing that is going to happen during the next 12-24 months is that there will be continued pressure on emerging markets, both equity prices and currency values. Quite simply, in a world of contracting risk, the required returns for these assets will increase. It has been too easy for too long to print money by taking dollars and turning them into BRICks. The BRICk house won’t stand up to this storm. Money has flown in too easily, and the world is about to find out that the abundance of capital meant that the projects didn’t necessarily justify investment but were funded anyway. For those who are still struggling with the “brick” thing, BRIC is the lingo for “Brazil, Russia, India and China”.

The “pile of stool” article I mentioned above discussed the three legs that have supported our equity market all getting sawed off simultaneously (Consumer, International, LBO). The LBO bid has provided a floor under stocks as well as lots of cash to reinvest. At any rate, in that article, I discussed a few links to the Industrial sector, which has benefited from international growth clearly. After I wrote that article, I realized that there are still some sacred cows that need milking. One that stands out is the airplane construction boom. While many believe that this long-cycle industry is immune from the credit crunch, I would remind folks that the capital used to buy these very expensive pieces of equipment isn’t cash. I understand that the orders are exceptionally strong, but so were semiconductor capital equipment orders in 2000. When things are tight, the orders are exaggerated so that a bigger allocation can be realized. Energy-related equipment is another area starting to get hit that could get clobbered. Energy demand has been a bit stronger, but the real issue has been fear of future demand exceeding supply availability. If the global economy slows, this pressure should abate. I wonder if there might be some double-ordering in that type of equipment as well.

The most concerning link to me is the consumer, who, like the Energizer Bunny, keeps going and going and going. In fact, despite the strong economy, the consumer has still managed to save almost nothing. We are at full employment, though there are certainly signs of weakening. Lord, help us if the jobs aren’t there, as it seems like many families are going to need 2nd and 3rd jobs to meet their rising mortgage costs. My concern is that providers of risk will curtail their appetite for non-mortgage consumer debt. Specifically, many people roll their card balances each month and play the teaser game – pay it off with a “balance transfer”. Well, if, as I expect will be the case, the consumer can’t get that teaser rate, then he will be stuck having to pay significantly higher credit card rates. The falling real estate markets and now the falling stock market could also hurt the consumer’s willingness to continue spending in excess of income. Interestingly, we haven’t seen consumer spending go negative for two straight quarters in quite some time. We are due:

fed 2

A client called me “Dr. Doom” the other day, a moniker to which I have never aspired. Still, though, I think that unlike the last two credit crunches (1987, 1998), the likely outcome this time recession. The impetus will be the weakening consumer. We are already seeing it at Wal-Mart, and I expect it will show up at high-end stores as well. 2nd homes, higher-yielding “conservative” investments (like REITS) are getting pounded and the overall housing market and stock market weakness may finally lead the consumer to behave more prudently. With that in mind, I have been shorting Coach (COH) lately (no position now). The stock has rolled over after an incredible run and has downside to 35-36 from its current 44.32 price.


Whole Foods (WFMI) has rallied back from the 38 level I had suggested would act as interim support. Time to sell/short that one again too near its 44.30 close. Another one of my watchlist stocks I have been shorting (no current position) is Altera (NASDAQ:ALTR). This semiconductor company has diverged greatly from its peer Xilinx (NASDAQ:XLNX) in terms of valuation and is one of the few semiconductor stocks close to its 50dma. I had traded this one from the long-side earlier this year, but it is expensive now at 22X. Amphenol (NYSE:APH) is another Tech stock rolling over. I really like the CEO there and their business strategy, but they are loaded with debt (something I am avoiding even more than usual) and valued too high if we are at a cyclical peak. Parker-Hannifin (NYSE:PH) isn’t one of my closely followed stocks, but is a sell/short between 95 and 97. This company has big exposure to the plane construction boom that I expect could run into funding issues. It has a slug of debt and has rolled over as well. The last potential short (and one that I intend to study more closely) is Valmont (NYSE:VMI). This Industrial stock has had a huge run, is trading at a historically high PE despite limited margin expansion potential. The company has some debt and, like several of the other stocks mentioned, could face difficulties rolling over (or at least higher borrowing costs) down the road. Also, the ability to finance acquisitions could become hampered.

They say in a bear market that only about 1 in 20 stocks is able to rally. One that has caught my attention is Bright Horizons Family Solutions (NYSE:BFAM) (42.66, $1.1 billion). I figure that as more consumers try to replace the income that is being lost to higher credit cards or mortgage rates, we will see some stay-at-home Moms or Dads return to the workforce (and require childcare services). BFAM caters to corporate employers. The stock has been consolidating now for two years (with the PE compressing from 32 to 20 – now at 22). Earnings estimates for 2008 just ticked up. The Return on Capital exceeds 20%. The balance sheet has no debt. 41 looks to be an interesting entry level with solid support at 37.50.

To conclude, I have been adjusting my expectations as I have seen the fallout occur much more severely than I had anticipated. The market is due for a correction, as is the economy. This looks to be a traditional 1-2 year bear market underway. To put faith in the Fed to somehow miraculously fix the fact that foolish loans and investments have been made (mortgages, LBOs, emerging markets and consumer debt, which isn’t fully recognized) is not a prudent investment strategy. There is a way out, but I don’t think our government is ready for it. We need to reverse the backlash against undocumented workers. Let’s open the borders to anyone that will come pay full price for a house! Unfortunately, as my suggestion made in jest suggests, I am unaware of anything that can quickly cure the credit crunch. If you do, please share with me!

Disclosures: I have no positions in any stock mentioned though expect to reestablish short positions in COH, ALTR and perhaps WFMI in the near future.