Liquidity Crisis Averted, Economic Crisis Exacerbated

by: Alan Brochstein, CFA

It has been almost 5 weeks since the Fed moved more aggressively than expected to address the unfolding sub-prime fallout. Given the return of the S&P 500 to and even slightly beyond its prior all-time high, many would judge that the bold actions have been successful. Indeed, if one-month return were the measure of Fed policy, Bernanke will ultimately be viewed like his two predecessors as a capable protector of our financial system. Unfortunately, the price he paid has yet to be fully recognized. The Fed didn’t do anything more than throw gasoline on a fire.

By easing, the Fed threw liquidity to everyone, when it really needs to be directed solely to the housing industry. While I think that reasonable people could debate even the role of the Fed addressing specifically housing (if a government solution is needed, it should be coming from elsewhere), very few would agree that the I-Banks needed bailed out for foolishly exposing themselves to excessive funding obligations for LBOs. As you can see in the chart above, the market had already returned pretty much to where it had traded prior to the big August swoon. In fact, the Fed chose to ease when stocks were still up year-to-date! In my opinion, they panicked after trying to restore confidence with their lame discount rate cut, skipping the meat and potatoes and going straight to dessert.

Well, after the last few days, the market has closed at its lowest point since the Fed’s move and the expectations for further cuts seem to be picking up. Hello! Doesn’t anyone understand that easing will not address the credit crunch without risking inflation? In the chart above, you can see that while the stock market was fooled by the Fed’s move, the dollar certainly wasn’t. In the table below, it is clear that the beneficiaries of the Fed’s largesse have not been the areas that needed help at all:

As you can see, clearly post-Fed, investors have fled for the safety of Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL). Kidding aside, large-cap technology and commodities have been the big gainers, while the Consumer Discretionary and Financial stocks have continued their poor performance prior to the move. Overall, the market has increased slightly. One can’t look at the economic numbers being released to make a judgment, as that will take 6-12 months to be known. Stocks, though, are supposed to be anticipatory. The market has voted.

Here’s a final thought. The Fed gives the green light, and the hedge funds step on the accelerator, buying anything and everything but the toxic waste (aka Financials and Consumer Discretionary). The foreigners too, who redeemed dollars in August, jump back in. Happy days are here again! Note, though, that the dollar has declined, commodities are soaring, stocks have advanced and bonds yields have strangely declined. One would usually expect that a weak dollar and rising commodity prices portend inflation and rising stock prices suggest economic growth, none of which bond-market investors typically cheer. While the bulls must be high-fiving and taking joy in their so-far-correct execution of the “don’t fight the Fed” and the “buy the dips” strategies, we bears surely are taking solace in the notion that it isn’t sustainable to have a declining currency, rapidly rising commodity prices, falling bond yields and a rising stock market that is so bifurcated by sector. I expect that the alpha-grabbers (hedge funds, who really were beta-grabbers) are going to start running the other direction soon. The universe of hedge funds has returned in excess of 9% year-to-date through September (source: Hedge Fund Research ), and I expect that we will see some locking in of profits sooner rather than later, especially if the market weakens just a bit more.

Disclosure: No positions in any stocks mentioned in this article