Wednesday, January 16, 2008

The Fed Fiddles

The US economy is slowing and many economists and most of the public believe we are either already in a recession or will be soon. I have said previously and still believe that we won’t get a recession from the bursting of the housing bubble. I must admit that my conviction about that has been shaken over the last several months as the economic statistics have deteriorated, but even now I don’t expect the economy to slow enough for an official recession. That doesn’t mean that the economy will not face some difficult times, but the US economy has proven to be very resilient over the years. A lot of that resilience is due to the fact that every time the US economy has slowed, the Federal Reserve has ridden to the rescue with lower interest rates.

I have no doubt that if Alan Greenspan were still in charge at the Fed that interest rates would be lower than they are today. Ben Bernanke has lowered rates by 100 basis points but the market still clamors for more. It appears from his speech last week that Bernanke finally agrees that the Fed needs to do more and another 50 basis point cut is widely expected at the next meeting at the end of the month. Indeed, many expect the cut to come before the next meeting, as if two weeks would make all the difference. Will another 50 basis point reduction in the Fed Funds rate be enough to stabilize markets?

2008 is barely two weeks old and the S&P 500 is down almost 6%. The NASDAQ is down almost 9%. Of the 5 broad asset classes we utilize in our portfolios, 4 are down year to date; the only broad asset class to gain is our fixed income component. Since the stock market peaked in mid-October, 3 of 5 asset classes are down. While this is disconcerting for clients, I am comfortable in the knowledge that in the 27 years of data we have analyzed for these asset classes, there have only been 2 full years when 3 of the asset classes have declined. And there has never been a full year when 4 declined. Furthermore, as bad as this year has started, the likelihood that the full year will end as bad as it started is minimal, although not impossible. Again, reviewing the data, I find 7 years that produced returns of 5% or less (as this strategy did in 2007). The year following produced a return of greater than 15% in 6 of those instances; 5 times produced a return of at least 20%. Only once did a sub 5% return repeat the following year (2002).

The economic effects of interest rate cuts take time to work their way through the economy. The effect on markets can be and usually is more immediate. Everything the Fed has done since August has been an attempt to provide liquidity to the credit markets. Those efforts are now finally starting to bear some fruit. While the headlines are about loan write offs and investments by sovereign wealth funds in the major banks, behind the scenes there are hopeful signs in the credit markets. A month ago the spread between LIBOR and Fed Funds was above 1%; that wide spread indicated reluctance by banks to lend to one another. That spread, after massive injections of cash by central banks around the world, has fallen to about 0.25%. In addition, the most recent Term Auction Facility by the Fed was awarded at 3.95%. The last auction in December was awarded at a rate of 4.67%. That would seem to indicate a slackening of demand for this credit from the Fed.

So even as the stock markets sell off over fears of a credit crunch induced recession, the credit crunch itself is already starting to ease. Does that mean all the troubles in the banking system are over? Probably not, but I believe the majority of the bad news has already been reported. Does it mean the economy will immediately regain its footing? Probably not since the economic effects won’t be felt for some time yet. Does that mean that the stock market will soon find a bottom? Maybe, but that depends as much on psychology as anything else; investors with cash will have to feel comfortable putting that cash at risk in the market.

The psychology of the market right now is as negative as it has been since the beginning of the bull market in late 2002. The American Association of Individual Investors weekly poll shows just 19.6% of respondents bullish, 58.9% bearish and 21.5% neutral. That is actually a lower number of bulls than the survey showed at the bottom of the market in October of 2002, so if we are not at a bottom, we are probably close. These surveys are generally trend following; as stocks rise the number of bulls rise and when stocks fall the number of bears rise. Turning points are found at the extremes and less than 20% bulls is an extreme. All those bears are merely future buyers.

And why wouldn’t the average investor be negative? The news has been relentlessly negative for months now. Home prices are falling, foreclosures are rising and banks are announcing huge loan losses. Oil is still over $90 and gas prices remain over $3 per gallon. Gold is setting record highs and politicians are touting their economic “stimulus” plans (none of which appears particularly stimulating). The spectre of stagflation has returned from the dark days of the Carter presidency and the dollar is hitting multi decade lows. Is there any good news on the economic front?

Well, actually there is some good news out there. Unemployment has risen slightly but remains much lower than the last recession:

Although we don’t have data from December yet, personal income was still rising at a decent rate in November:

As is consumption:

Core inflation is higher than I would like, but not outside the range we’ve seen over the last several years:

Despite the headlines about a credit crunch, commercial banks are still lending:

Average hourly earnings are rising at a healthy rate:

Despite all the Grinchy talk about a lousy Christmas season, retail sales were still up 5% year over year in December:

Exports are still booming:

And imports, which tend to fall in a recession, are also still rising.

I don’t mean to imply that all is sunny with the US economy. Even some of these positive statistics can be viewed as negative. Unemployment is low but rising and in the last recession, stocks didn’t stop falling until the unemployment rate peaked. Inflation is still too high. The expansion in commercial bank loans is partially due to the fact that banks are taking loans back on their books that they can’t finance off balance sheet. Exports are booming because the dollar is weak and imports are rising because of higher oil prices. But there are also positives not seen here. Corporate profits, outside of the financial sector, are still rising. Insiders are buying their own stock at very high rates. The financial sector is having little difficulty raising new capital, if on unfavorable terms.

The Federal Reserve will lower interest rates again and the economy will recover from the sub prime induced credit crunch. The long term problems with our economy will not be solved by another dose of easy credit though. Our government needs to spend less and cut the tax burden, especially at the corporate level. Something has to be done about the costs of Social Security and Medicare. Trade needs to be furthered expanded, not restricted by a populist, xenophobic Congress. But these are political problems that will not be solved before this slowdown is over. If history is any guide, they won’t be solved until they become full fledged crises. Some believe that the crisis has already arrived and the US is in permanent decline. I don’t believe that and investors who have bet on that in the past have always been disappointed.

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