Fed Cuts Rate -- What will the Stock
Market Do Now? Part 2
By Chris Ciovacco
October 17, 2007
"The dollar has been sliding since the
Fed last week cut interest rates by a larger-than-expected
half percentage point. Since then, disappointing U.S.
economic data have stoked expectations that another rate cut
is on the way. Lower interest rates, used to jump-start an
economy, can weaken a currency as investors transfer funds
to countries where their deposits and fixed-income
investments bring higher returns.As the dollar sinks,
consumers find imported products— Australian wines, Japanese
cars or Chinese toys — are more expensive. "
Associated Press -09/28/2007
Purchasing Power is of Primary Importance
Since our money is only as valuable as what
it can buy for us, a well thought out investment strategy
should always strike a balance between preservation of
capital and preservation of purchasing power. On the one
hand, an approach which is too conservative can leave an
investor wondering how their standard of living seems to be
going backward even though their CDs are earning interest.
On the other hand, an overly aggressive approach can lead to
sleepless nights and large losses, from which it is
difficult to recover. We will attempt to show why in the age
of credit expansion it may be more important than ever to
approach investing from both ends of the risk spectrum. As a
money manager and financial advisor, my task is similar to a
cardiologist who instructs his patients to remain active
after a heart attack while at the same time avoiding too
much stress on their recently damaged hearts. If the patient
becomes too sedentary, it can be costly. If the patient
adopts an overly ambitious exercise regimen it can also be
harmful. Balance is the key.
Perception Is Reality
With the Federal Reserve (Fed) somewhat
surprising Wall Street with a .50% reduction in interest
rates, we have officially moved from a cycle of increasing
rates (June 2004 – June 2006), to a cycle of flat rates
(July 2006 – August 2007), to a cycle of declining rates
(September 2007 - ?). While the actual impact the Fed has on
market interest rates has diminished over time, Wall
Street’s perception is the Fed still matters a great deal.
What matters to us is the new Fed cycle will influence
investors’ actions, and thus influence the relative returns
of different asset classes such stocks, bonds, commodities,
timber and commercial real estate.
Why Did The Fed Lower Rates?
Wall Street has been packaging more and more
complex investments over the years, such as bundling
traditional mortgages with sub-prime mortgages and selling a
stake in the form of a bond. Investors, including large
institutions and hedge funds, have purchased portions of
these mortgage pools after being told the diversified mix of
mortgages minimizes their risk. Everything looks fine until
someone stops paying somewhere along the food chain, and
matters become even worse when several parties
simultaneously stop paying. The ever increasing complexity
of these derivative investment vehicles has caused
participants to question how much risk they are really
exposed to. The complexity also creates uncertainty as to
the future need for capital in the event more defaults
occur. Another problem tied to the complex and uncertain
nature of these investments is a growing mistrust between
counterparties. Since many banks, institutions, and hedge
funds do not know what the future may hold, the tendency is
to hold onto your cash until the smoke clears. According to
the Economist, “it could take months to put prices on
these complicated mix of investments”. As a result, the
availability of credit has diminished in recent weeks.
Obviously, tighter credit conditions are the last thing a
housing market on the ropes needs. The Fed knows a
significant portion of our economic growth since 2000 has
been fueled by low interest rates, easy access to credit,
and rising home values. They lowered interest rates in an
effort to slow the negative momentum.
The Weakening Dollar: Fed’s Actions Have Consequences
Lower interest rates lead to lower borrowing
costs, which increases the demand for loans and access to
credit. In the fractional banking system, new loans create
new money which increases (or inflates) the money supply and
reduces the purchasing power of the dollars we currently
hold. More money chasing a relatively stable amount of goods
and services can lead to “bad” price inflation. Monetary
inflation can also lead to rising prices in stocks or real
estate or “good” inflation. Newly created money also
devalues the money in your pocket via simple supply and
demand. Therefore, the terms inflation, a declining U.S.
dollar, currency debasement, etc. all refer to an expanding
money supply. A hedge against inflation is also a hedge
against the declining value of any paper or fiat currency.
Credit creation and money supply expansion are not limited
to the United States; we just may be the leader in terms of
being addicted to credit.A Better Read on the
Bernanke Fed
Wall Street coined the term “Greenspan put”
to describe the former Fed chairman’s willingness to quickly
lower interest rates during periods of “instability”, which
is a politically correct way of describing a period when
risk takers are suffering large losses. A put contract is
like an insurance policy which covers or offsets investment
losses. Therefore, the Greenspan put referred to the
confidence risk takers had in Mr. Greenspan’s willingness to
protect them with rate cuts in declining asset markets. It
is similar to a teenager who may feel they can take more
behavioral risks knowing their parents would ride to the
rescue in their time of need. As you might imagine, the
Greenspan put helped increase the risk tolerance of many
investors, which in turn helped fuel bubbles in tech stocks
and housing. The Greenspan put was a two-pronged bubble
blower. Individuals and institutions could invest money
borrowed at lower rates. As an added bonus, investors also
got an insurance policy against being hurt too badly in
declining asset markets.
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With a new sheriff in town, Chairman Bernanke, the
investment community was concerned the days of the Fed
riding to the rescue when risky investments began to sour
may be over. As discussed above, lower interest rates help
fuel both monetary and price inflation. Therefore, the Fed’s
inflation-fighting credibility is at risk when the
institution appears to mirror the Greenspan Fed. Anyone who
has followed Bernanke’s career was not surprised when the
Fed recently sent a loud message indicating the Greenspan
put is alive and well. In fact, we may see a turbo-charged
Bernanke put in the form of faster and larger cuts.
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In a
well-written article by Mike Swanson (wallstreetwindow.com), he
states:
Bernanke built his
career on a doctoral thesis that claimed the Fed didn't cut rates
fast enough during the 1929 stock market crash. What Bernanke
believes is the Fed should have cut rates all at once during the
start of the bear market instead of gradually over two years. He
seems to be putting this belief to work right now.
Chris Ciovacco
Ciovacco
Capital Management
Chris
Ciovacco is the Chief Investment Officer for Ciovacco Capital
Management, LLC. More on the web at
www.ciovaccocapital.com
All material presented herein is believed to be
reliable but we cannot attest to its accuracy. Investment
recommendations may change and readers are urged to check with their
investment counselors and tax advisors before making any investment
decisions. Opinions expressed in these reports may change without
prior notice. This memorandum is based on information available to
the public. No representation is made that it is accurate or
complete. This memorandum is not an offer to buy or sell or a
solicitation of an offer to buy or sell the securities mentioned.
The investments discussed or recommended in this report may be
unsuitable for investors depending on their specific investment
objectives and financial position. Past performance is not
necessarily a guide to future performance. The price or value of the
investments to which this report relates, either directly or
indirectly, may fall or rise against the interest of investors. All
prices and yields contained in this report are subject to change
without notice. This information is based on hypothetical
assumptions and is intended for illustrative purposes only. THERE
ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY,
COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN
THIS ARTICLE. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.
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TOPIC:
Historical Effect Of Fed Interest Rate Cuts On The Stock Market
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