Out
of Control, Pt 2
By
John Riley
Chief Strategist
06/06/08
A few years
ago we produced a research piece that showed how the Fed was not
in as much control of things as you might think.
Friday’s action
with the Dow down 400 pts and oil up over 11 Dollars underscores
that point. Unemployment jumped the most in over 20 years and the
Fed’s hand is being forced into doing something it doesn’t
want to do.
CAUTION:
The next few paragraphs of this report will discuss some economic
theory. Do not read unless you are on a couch or in a prone position
because spontaneous sleep may occur!
When the Fed lowers and
raises interest rates, they are trying to affect the economy by
influencing the money supply. If they want to give the economy a
boost, they lower rates, thereby increasing the money supply and
the economy gets a bit more fuel to get moving. If they want to
slow the economy, they raise rates, decreasing the money supply
and slowing the economy.
Statistics confirm that
as the Fed raises rates, the money supply growth slows and as they
lower rates money supply growth increases.
But how does the money
supply actually go up or down? Does the Fed print money and throw
it out the windows of the tallest buildings? No, actually one way
they effect the money supply is through the banking system via loans.
As rates go up, less people want to borrow, as rates go down, there
are more borrowers.
There is a point at which
new debt can be a catalyst for new economic growth and at another
point it becomes a drag on the economy. If the debt ratios are getting
out of hand, the Fed can raise rates to slow the growth of debt
and the economy. If the Fed does not act, the economy could collapse
under the weight of the excess debt burden.
So we should see this
in the statistics, shouldn’t we? The chart below shows various
periods of the Fed raising rates and lowering rates and what the
growth of debt was during those time periods. But the Fed doesn’t
raise or lower rates for the same amounts of months each time. So
we divided the overall growth of the debt by the number of months
the Fed maintained a particular direction of the Federal Funds Rate.
In this way we are able to compare different time periods where
one may be significantly longer than others.
What we found was nothing.
It didn’t matter what the Fed was doing with interest rates.
Debt growth seemed to be unaffected by rising or declining interest
rates over the past decade.
Source: Fed Reserve; Format CIS
In the early 1990’s,
the Fed dropped rates by 63%. Then they doubled rates in almost
a year and a half. Total Debt growth during both periods was almost
identical.
In the late 1990’s
rates went up about 41% and debt grew more than in the early 1990’s
when the Fed was dropping rates. (Debt growth should have slowed.)
From August 2000 through
May 2004 the Fed lowered rates by 84% and debt, as one would expect,
rose even more than the previous period, when the Fed was raising
rates.
But then the Fed raised
rates over 400% from June 2004 to August of 2006, and shockingly
debt continued to grow even faster than when they were lowering
rates.
What this tells us is
that something else is influencing the growth of debt and the Fed
is ineffective and has lost whatever control they (and Wall Street’s
marketing machine) thought hey had.
Now comes 2007
and the Fed’s panic move to lower rates starting in July.
(See the Fed
Buys A Round) Instead of the expected increase in debt growth,
its growth has slowed. This doesn’t bode well for the Fed’s
plans to keep the economy from recession.
2008 brought
even more challenges as the derivative mess and sub-prime mortgages
forced the Fed to play “Bail out of last resort” for
investment bankers that took on too much risk and lost the game.
(See Trillion
Dollar Secret)
But the Fed is also doing
a balancing act. The Dollar has been collapsing for several years
because of the Fed’s loose money policies and the growth of
debt. So to protect the Dollar, the Fed has to raise rates, which
it was doing, to no avail, until July of 2007. Then along comes
the housing crisis and the banking crisis and the derivative crisis
and the Fed has to lower rates like crazy to keep the economy from
caving in. This also greases the skids for the dollar to slide even
further down.
Then we have oil decide
to skyrocket, pushing inflation higher and the Fed needs to raise
rates to fight inflation. But they don’t, or haven’t
yet.
And then, after
weeks of specutlation, another investment bank, Lehman Brothers,
is in need of cash (Lehman
Raising $6B in Capital: Expects $2.8B Loss) to stay afloat,
unemployment jumps to 5.5% and the market drops 400 points. To bail
out the banks, again, and give the economy a boost and keep the
stock market humming, the Fed needs to lower rates.
Except that along with
this week’s news, the Dollar dropped some more. To protect
the Dollar and fight inflation, the Fed needs to raise rates.
Which brings us back
to the chart above and the point of this report, the Fed is out
of control. It no longer controls the things that make a difference
to the economy. There is nothing they can do to reduce the consumption
of oil and other commodities by developing nations overseas. There
is nothing they can do about the growth of debt in this country.
There is nothing they can do about the time bombs of derivatives
and sub-prime mortgages and other esoteric investments buried in
the balance sheets of our nation’s top banks.
They are not willing
to take the necessary action to protect the Dollar and fend off
inflation. Raising rates would kill the economy. Lowering rates
kills the Dollar and brings hyper-inflation.
What is the Fed to do?
The way we see it at
Cornerstone, the trends are already in place and there is little
the Fed can do about them. They can delay and they can interfere,
but the macro trends are too powerful and the Fed is powerless to
do anything about them. They will talk, they will change rules,
they may even do something with interest rates. But this week’s
action, more than anything else, showed that the Fed was out of
control on the issues that matter.
Investors are
not powerless though. There is a wide range of investment vehicles
that can take advantage of the problems that are giving the Fed
a headache.
Below is a review of
current market charts and our strategy.
As if on cue,
the Dow failed at its moving average line (Blue line above) and
started to head lower. Although Friday’s decline of 400 points
was shocking, it hasn’t made a new low. A break below 11750
would confirm a downtrend.
The P&F chart above show the market gave a sell signal on Friday,
which was preceded by several sell signals over the past few months.
Currently the downside target for the Dow is about 11750. A break
below would likely send the market much lower.
The S&P 500 has followed
a similar path as the Dow, but its decline is not quite as bad.
The S&P would have to decline below 1250 to confirm that a downtrend
has developed.
The
NASDAQ’s decline on Friday was not as harrowing. The market
has had a bounce back, and so far has been running in place for
the past month.
This chart should be scaring the Fed. The Finance Index has declined
back to the panic lows of the first quarter. A further decline means
that the Fed’s actions have been meaningless.
Worse
yet is the Banking Index. It dropped below the March lows a few
days ago and Friday’s action made things even worse.
Below are a
few key banks. If things were getting better, wouldn’t their
stocks be doing better?
CitiGroup
– Has dropped down to the march levels, not quite a new low
yet.
JP Morgan
– Although not at its March lows, Friday’s action confirms
a downtrend is in place.
Bank
of America – It dropped below it’s March low
a couple of weeks ago and is still looking for a bottom. It keeps
knifing lower, and on increasing volume. This looks bad.
Wachovia
– Like Bank of America, Wachovia can’t seem to find
the bottom. How bad are things at Wachovia? Only time will tell.
Washington
Mutual – They weren’t supposed to be like the
other banks. They were supposed to have a more conservative balance
sheet and strategies. Looks like that isn’t so as they too
are having trouble with finding a bottom.
If you think
these banks look bad, the brokers look just as bad.
Lehman
Brothers – They have been in the news recently with
stories flying around about how much of a cash infusion they need.
(Does this remind anybody of another firm a few months ago?)
Merrill
Lynch – Even Mother Merrill has not been immune to
the concerns about liquidity and questionable investments. They
are flirting with their March lows. A drop much further would confirm
a continuation of the decline.
Morgan
Stanley – Friday’s action reverses an attempted
rally. A drop below 40 would be bad and put the March lows in their
sights.
UBS
– Their rebound bounce off their March low was short lived
as new revelations about bad loans and billions in write-offs has
sent the stock below the March lows.
If the Fed’s bailout
of Bear Stearns was supposed to stabilize the Finance and Banking
industries, they have fallen very short.
Our strategy
is simple, we are avoiding the US market and especially the banking
and finance stocks. Hedges on the US Equity markets should give
us profits as the US market declines. Where appropriate, we will
also us hedges on the finance industry, as we believe there are
other shoes to drop and the Fed has not contained the balance sheet
and derivative problems.
The Federal
Reserve controls short term interest rates. The market controls
long term rates. It appears that the recent run up in rates has
broken above the previous highs and as inflation continues to be
a problem, long term investors will probably demand more compensation
driving rates even higher.
The longer
term chart of the 30 year Treasury show that rates have been bottoming
for more than 2 years. After a 24 +/- year decline, and knowing
that markets are cyclical, what direction should one expect to be
the next major long term trend for interest rates, up or down?
It is our view
that the Dollar is still the catalyst for everything. The recent
“rally” in the Dollar has been much ado about nothing.
As the Dollar declines, inflation gets worse in the US. Will the
Fed raise S/T rates to protect the Dollar and fight inflation, or
will they keep rates the same or lower them to help bail out the
ailing banks, brokerages, mortgage holders and the stumbling economy?
Gold has had
a 15% correction, even with the Dollar declining. Is Gold’s
position as a hedge on the falling Dollar over? We don’t think
so. We’ve seen this before. Gold seems to move in spurts.
You can see it rallied quickly for much of 2005 and into 2006. Then
it traded sideways for about a year. Then it spurted up again. This
could be the start of a sideways period, but with the potential
for a US Dollar crash, I wouldn’t rule out a significant rally.
Gold stocks have traded in spurts and sideways much more clearly
than the metal itself. For almost a year and a half they ran in
place. Since October of 07 they have gone nowhere. But, because
of the Dollar’s increasing risk, Gold and Gold stocks seem
to be the safe bet.
The
investment superstar has been Oil. It keeps chugging along and this
week, as if to remind everyone that it still had some game in it,
it put together back to back records, record single day advances
and record high closing prices.
Fundamentals are strong
and getting stronger for oil. Consumption keeps going up and supply
can’t keep up. Then throw in the potential for a new Middle
Eastern war, (take your pick, it could be the US vs Iran or Israel
vs Iran or ???), and you add on a war premium that could go up to
…. We won’t even speculate.
This is yet
another area that the Fed has no control over. Unless the Fed has
been dabbling in shuttle diplomacy on the side, this is an area
way out of their sphere of control.
Based on technicals though,
oil’s chart is over extended. A serious correction should
be in the offing and we wouldn’t be surprised to see oil at
$85. When will it happen? Who knows. It may never happen. Fundamentals
may catch up to the price or a new war could break out that makes
the war premium permanent.
Mainly because of the
steepness of oil’s advance and the increasing percentage of
portfolios it was representing, we have been reducing our exposure
to oil and natural resources for several months, in anticipation
of a severe or extended correction.
Summary:
Regardless of what they want you to believe, the Fed has become
ineffective against the real problems and is unable to do anything
to reverse the trends that are in place.
Nothing is surprising
us though and our strategy is taking advantage of much of what is
causing the market fits.
Below are a few headlines
of interest:
Dollar
Dilemmas - The Economist – “FOR several years
two rules have governed America's dollar policy. The first was that
only the treasury secretary talked at length about the greenback.
The second was that he repeated a vacuous mantra about a strong
dollar being in America's interests, even as everyone knew policymakers
quietly welcomed its slide.”
Oil
Crisis: World Powers Blame Each Other – “Leaders
of the world's major powers voiced alarm on Saturday after the unprecedented
one-day hike in the price of crude, expected to jolt world economy,
trading blame but taking no responsibility.”
Oil
Rises to Record on Weakening Dollar – “Crude
oil surged more than $10 a barrel to a record as the dollar weakened
after the U.S. unemployment rate grew the most in two decades and
Morgan Stanley said prices may reach $150 within a month.”
Two
Fed Bank Presidents Warn About Lending to Securities Firms –
NYT – “Two Federal Reserve Bank presidents warned
in separate speeches on Thursday that the central bank’s decision
in March to lend to securities firms might sow the seeds of further
financial crises.”
Lehman
Raising $6B in cCApital; Expects $2.8B Loss - "Lehman Brothers
Holdings Inc. on Monday said it will raise $6 billion in new capital
to shore up its balance sheet after saying it expects to post an
unexpectedly large second-quarter loss of nearly $3 billion."
Israel
Eyes Iran Attack - NY Post – “An Israeli attack
on Iran's suspected nuclear bomb-making sites is "unavoidable"
and would have US support, the Jewish state's deputy prime minister
was quoted as saying yesterday.”
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