Friday, August 17, 2007

The More Things Change....

First, the mea culpa. August 8th and again last week, I predicted that the lows for this correction had been seen. Obviously, I was wrong by a few hundred Dow points. This just serves to prove that no matter how long you’ve been doing this, the future course of markets is still unpredictable. I still believe that the fundamentals of the economy are basically sound and that the bull market in stocks is not over, but I must admit that there was a point yesterday when I was doubting that. At the low yesterday, the Dow was down almost 350 points and my stomach was churning and the easiest thing in the world would have been to sell and relieve that stress. But I didn’t do that; successful investing is as much about controlling your emotions as anything else and when the market is acting irrationally, one has to resist the temptation to join in. And today (or at least this morning) we are getting some relief.

The Federal Reserve cut the discount rate this morning and the stock market responded immediately by jumping over 300 points at the open. As I write this, the market is up about 150, so there is still a question as to whether this rally is sustainable. I think it will be but only time will tell if the Fed’s action this morning will mark the bottom of this correction.

Cutting the discount rate is more a symbolic act than an actual remedy to the current problems in the credit markets. The discount rate is the rate the Fed charges member banks to borrow directly from the Fed. This rate is higher now than the Federal Funds rate, which is the rate at which member banks loan money to each other. Traditionally, the discount rate was lower than the Fed Funds rate and if banks were borrowing from the Fed it was seen as a drastic measure. A few years ago, the Fed let the discount rate drift above Fed Funds and it remains there today. So if banks can borrow from each other at 5.25% and the discount window is charging 5.75%, why would a bank go to the discount window? Well, the fact is they probably won’t. I think this was the Fed’s way of buying time until the next FOMC meeting when they will probably cut the Fed Funds rate, which is much more important to the credit markets. The statement that accompanied the discount cut this morning had the Fed acknowledging that the “risks to economic growth have grown appreciably”. I think that is their way of letting the market know that a Fed Funds rate cut is coming at the next meeting. And that is the source of the title of this essay.

During the Greenspan era, every crisis, no matter how trivial, was met with a cut in interest rates. That tendency came to be known as the Greenspan put; the market came to expect that any stress in the market would be solved by Greenspan providing another dose of liquidity to the markets. That was the source of the stock market bubble in the late 90s and the housing market bubble of the early 00s. The easy availability of credit encouraged risk taking and the Greenspan put reinforced it. What everyone has been wondering these last few weeks is how would Bernanke react? And today, I think we got the answer. He will act to preserve the status quo – easy credit. And once again, the speculators who took too much risk will be bailed out by the Fed. Moral hazard is alive and well.

In a free market economy, those who make poor financial decisions (such as loaning money to people who can’t pay it back) would have to pay for those mistakes. In an economy driven by easy credit, those who make poor decisions don’t get their full comeuppance. They may lose a little, but ultimately the Fed will bail them out of their poor decisions. If the Fed starts a rate cutting cycle here and rates fall, all those people who took out variable rate mortgages will have the ability to refinance at lower rates and the number of foreclosures will be less than otherwise. I suppose that is good for the people who made that mistake, but the rest of us will pay for it in the form of higher inflation. Those who act prudently, who save and invest, will not be rewarded as they should because interest rates will be lower than the market clearing rate. Many people complain about the low savings rate, but why save when the Fed makes sure that interest rates are so low that saving is a losing game after considering inflation and taxes? Those who act prudently are punished and those who take inordinate risks are rewarded. The easy availability of credit also distorts investment. Investments are driven more by the credit terms than their actual economic desirability.

So where do we go from here? My guess is that the Fed will cut rates at the next meeting and quite possibly at the October meeting as well. If that is the case, stocks can be assigned a higher multiple and the likely reaction is a return of the bull market. There will come a day when the credit bubble ends, but I suspect we are not there yet. The Fed has room to cut rates more if need be and they are apparently willing to do just that. The key is still economic growth and the world economy is still performing quite well. I will be reviewing the economic stats over the weekend and will put out a full report next week, but so far I have seen nothing that leads me to believe that the economy has been hurt all that much by these credit issues. The sub prime debacle is relatively small compared to GDP and with the Fed now providing relief, the economy is likely to maintain its current path. If that is the case and earnings continue to grow, the market will follow.

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