THE
FED’S “HAIL MARY PASS”
Leading up to the Federal Reserve’s November 6 decision on interest rates, the economic outlook had become somewhat more tenuous. The third quarter, according to preliminary figures, showed the economy grew at a still-healthy 3.1 percent annual rate; however, virtually everyone expected to see a markedly weaker performance heading into the last quarter of the year. It was widely recognized that much of the third quarter’s respectable growth was goosed along by record car sales (many of them at no interest); thus, with that pop out of the way, everyone expected the fourth quarter to fall off. Make no mistake, though; until very recently, the Federal Reserve—though its “bias” recently has been toward the greater risks that the economy would weaken—did not seem overly alarmed.
Another ingredient we must add to last week’s decision-making process is the surprising G.O.P. sweep of both houses of Congress. The vast majority of experts agree that this will translate—at least over the neat term—into significantly higher federal budget deficits (and that’s even if the president does not get us mired in a lengthy involvement in the Middle East). Part of the reason, though, is that the economy is likely to receive some form of stimulus from Washington in the form of solidified or additional tax cuts. Thus, many who predicted that the Fed would do little or nothing last week thought this, in great part, because they thought the Fed would keep some “ammunition” in abeyance while waiting to see what fiscal policy was going to do to help the economy.
Last but not least—and whatever folks’ views on how much the economy was slipping—the stock market had staged a torrid rally since plumbing new lows in early October. As I’ll describe further along, one of Greenspan’s best hopes of stanching or reversing the deflationary bleeding that has begun in the economy is to reinflate the stock market bubble. With the market having rallied on its own, many thought, the Fed might be better doing nothing; such would have indicated that—in spite of the slowing in the fourth quarter—the central bank was not becoming unduly alarmed.
Against this backdrop, though, the Fed gave the markets quite a surprise, lowering both the federal funds and discount rates to, respectively, 1.25 percent and 0.75 percent. Immediately, those pundits who were predicting something quite different (meaning the overwhelming majority of them) tripped over each other in asking, “What did the Fed see that we didn’t?” Wall Street pondered that too; and, by appearances, obviously didn’t like the few possible answers. If the Fed hoped to goose the stock market through technical resistance levels with this move, it failed--at least for the time being. But, depending on what goes on with all the war talk and such, what I term the central bank’s “Hail Mary pass” may still work out, at least for a while.
ECONOMY SLIPPING FASTER?
On October 23, the Fed released its latest so-called Beige Book on the economy. By and large—while not insinuating that we were remotely headed for a second recessionary “dip”—the report none the less was of an economy whose growth rate had virtually ground to a halt. This was nothing new or different on its face; however, I have to believe that the way in which growth was slowing anew has the Fed very concerned.
Up until recently, consumers—bolstered by record levels of mortgage refinancings and with a job market that had not yet deteriorated too badly—continued to borrow and spend with abandon. This has been changing in recent months. The job picture has turned worse again; as I detailed in one of my many recent updates, new layoff announcements jumped by 100,000 in October to their highest levels since January. The future looks no brighter; in fact, Yours Truly believes that after the beginning of the year, auto makers all by themselves will dramatically add to the ranks of the jobless.
This combined with continuing talk of war and a stock market which still enjoys little long-term confidence even after the recent rally have combined to drive consumer sentiment figures lower than they’ve been during this bear market. As a result, two trends—equally worrisome to the Fed—have been taking shape. One is lower spending. In September—and in spite of a healthy rise in incomes—consumer spending declined by 0.4 percent, its largest decline in 10 months. Most forecasts are for a continuation of this trend, as consumers—who borrowed and spent not only above and beyond the call of duty, but way beyond even THAT—finally are pulling in their horns.
The second trend has also taken shape more recently: a higher savings rate. While cutting back on spending over the last few months, American’s savings rate (which, as some of you will remember, was microscopic for a long time) is suddenly approaching an annualized 5 percent level.) Some people are coming to their senses after all; spending less, shopping more wisely, saving more for a rainy day and, in general, behaving much more responsibly; not to mention behaving as if they finally understand that the economy and financial markets might NOT roar back to life in the near term.
Both of these trends, of course, will doom any hope of “the economy” growing faster (I deal with this subject at great length in my recently updated and expanded essay “Understanding the Game,” which you’ll be receiving separately in the near future.) Keep in mind that consumer spending comprises two-thirds of all economic activity; and if we all are finally going to trim back, the chances of the broader economy even stabilizing—let alone growing—are diminished.
This means that business spending might even have further to fall. Between tighter credit conditions and uncertainty over Iraq and all, businesses have not been able to grow their spending as have consumers. Now, if consumers are going to be taking an extended vacation from high levels of activity, there is even less reason for business to expand. This means more layoffs as they try to defend at least some profits, and a continuing funk for those many companies who supply new software, equipment and other items that businesses need to expand and increase their productivity.
PROFIT “GROWTH” IS QUESTIONABLE
I mentioned the auto makers a bit ago. This sector soon may well kill the employment picture—and hopes for a rebound in the broader economy—all by itself. The “Big 3” have continued to lose market share to foreign imports. In order to keep things from being even worse, they have boosted sales by giving away discounts, low (or no) interest financing, and all the rest. During this time, profits have still been hard to come by. But even with reduced profitability, it’s been tough to cut workers; those cars that are being given away have still moved at a fast pace; not allowing for layoffs.
With the frenzy having peaked—and with annualized sales forecast to drop off by an average of 15 percent in 2003—the time is nearly at hand when the car makers will see their way clear to lay off workers. This nasty choice will be repeated in other industries as well in the quarters ahead; but perhaps no more dramatically than I foresee for Daimler-Chrysler, Ford and General Motors.
This could, of course, strengthen a vicious circle where layoffs translate into lower economic activity which—in turn—translates into even more layoffs.
Another angle to Corporate America’s “profit” picture has to be examined as well. Much was recently made by stock market bulls of the fact that better than 70% of the companies in the S&P 500 who have announced third quarter results either met or beat “expectations.” The key thing here is to define these expectations. For starters, remember that year-over-year comparisons are based on the drop in activity last year due to September 11. So, for some industries in particular, “growth” in revenues and earnings versus Q3 of 2001 doesn’t mean very much.
Second, it’s also important to remember that many companies had (in some cases, more than once) previously REDUCED their forecasts for Q3 revenues and earnings. Thus, meeting or beating those figures wasn’t necessarily any great feat. As UBS-Paine Weber’s Art Cashin quipped recently in talking about the somewhat disingenuous way in which this “good news” was being pushed, these companies weren’t unlike your college freshman who comes home from school one day with the terrible news that he’s about to be expelled. A few days later, he comes home with a report card full of “F’s”: but joyfully announces, “I’m not going to get kicked out of college after all!”
Any way you look at it, the outlook for legitimate, future profits remains poor.
Perhaps more than any other reason, Fed officials since their decision to lower short term rates by 50 basis points have pointed to this as evidence not only that the economy remains “in a soft spot,” but, particularly, faces virtually no threat of higher inflation. With “pricing power” non-existent as a means for most companies to shore up bottom lines, therefore, the Fed can err on the side of being too accommodative.
THE FED’S GAMBLE
But by taking the action that it did, the Fed wanted to send a signal that it was cognizant of the risks of deflation. The growing perception that we are slipping into a long period of such stagnation and slowly falling prices for many goods affects future profits as well as present ones. Just like Japan’s policy makers have learned, few businesses will—even if they qualify—go out today and raise money by selling either debt or equity for capital goods that they think will be cheaper a year from now. One of the whole points about “investing” in the future is the expectation that even modestly rising prices for what YOU sell will help pay the bill for acquiring the means to produce them now. Likewise, consumers too will be less inclined to spend money now, if they perceive that the same items can be purchased more cheaply down the road. Remember—in the case of both business and consumer activity, it does not (and, in the latter case, has not—required a precipitous decline in activity to stall the overall economy. All it requires is no new growth.
One important thing the central bank doubtless also had in mind—at least in part—was making it even more painful for investors to sit on their hands; and on their cash. One of the things that has surprised a lot of market mavens over the last year is that institutional and individual investors alike did not rush to take money out of money market funds with paltry yields and throw it at stocks. Better to earn a percent or so, than lose chunks of principal trying to catch a falling knife, they correctly told themselves.
Now, though, you’ll REALLY need a microscope to find your rate of return on short-term savings. Money market funds are having to cut expenses to keep any positive yield, and to keep their share prices from breaking the industry norm of $1.00 per share. In the case of money market funds within higher-expense variable annuities, investors in some of them were actually losing a bit this year, even before the Fed’s latest move.
The Fed hopes that—with the last month’s stock market rally as a supposed example of what you might “miss” by staying in short term savings with no reward—some will finally relent and help fuel a financial bull market, which in turn would presumably bring businesses and lenders both out of their stupor. If major moves of savings find their way back into stocks, the market’s rise would feed on itself, and credit conditions would improve.
As many (including Yours Truly) have written, there is no shortage of money on the sidelines to fuel such a move. Between institutions and individuals, there is well over $5 trillion in short-term savings which could be redeployed into the stock market. If even a fifth of this were moved into stocks, much of the pressure would be off the Fed; the stock market would—at least for a time—break its nearly three year down trend, and businesses would begin feeling better about life. Last but not least, overall consumer confidence would likely be boosted by a rising stock market.
This is the Fed’s gamble. For all the recent second-guessing over why they were unable to “spot” the 1990’s bubble or, later, let the air out more gently, the Fed did figure one thing out. That is, there is no hope for the economy to grow significantly without enabling and encouraging a new one. That’s why the Fed cut rates by 50 basis points; in part, it wants to drive the perceived “pain” of holding cash so high that, whatever the risks, the owner of the $5 trillion plus in those areas finally surrender.
If I’ve said it once, I’ve said it a million times: Never underestimate the ability of a central bank to inflate its way out of trouble. Make no mistake—the odds—not to mention the laws of mathematics—are still decidedly against the central bank, and would be if they’d taken rates all the way to zero last week. However, even Japan in the last dozen years experienced several instances where, for as long as two or three quarters, stocks and the economy rallied sharply in response to monetary stimulus. The same will happen here from time to time as well.
Frankly, I’d be more jazzed up over the possibility of such a broad, counter-trend rally—even a cyclical bull market—if it weren’t for three things:
First, the threat of war and an invasion of Iraq still exist. True, it presently looks as though Saddam might cry “Uncle,” if just for show. But we’re likely to have both Iraq and the broader, largely undefined risk of “terror” to grapple with indefinitely. How ironic if President Bush finally has the ingredients and succeeds in implementing some good tax and economic policies (to go with the Fed’s aggressiveness), only to have it all fail because too many of us are waiting to see whether we end up in a multi-year quagmire! This uncertainty alone suggests that—easier credit or no—activity will remain sluggish.
Second, as I’ve already said, fundamentals still stink for most businesses. The market has no fundamentals to rally on; hardly even, in fact, much legitimate hope of improving fundamentals. As long as this lasts, each rally will be fueled chiefly, if not exclusively, by a combination of hope and money chasing better returns. Thus, they will be suspect, and will probably prove fleeting. To get the money flows sufficient to break the stock market above its long-term trend line, investors may want to wait until legitimate improvement comes for earnings.
Thirdly—and this is the “biggie” near-term—the stock market after its latest strong run may have already “priced in” a modestly improved environment. More so, however, the market appears hemmed in technically. The major averages were recently able to break back above their 50 day moving averages. They did this briefly in August as well, after a sharp rally—only to quickly falter. This time around, they need to stay above those levels (which I update from time to time on my Hotline, e-mails and on the Members Page of my web site.) Then, they will need to mount sufficient momentum to break above longer-term “resistance.” The approximate levels to watch are 9300 on the Dow Jones Industrials, 1000 on the S&P 500 and 1415 on the Nasdaq Composite.
Were it not for the Iraq issue hanging over our heads, I’d be betting on the market (and the Fed) eventually succeeding, and putting in a sort of quick cyclical bull market before the longer-term secular bearish trends reasserted themselves. As it is, I still think it best to err on the side of caution. In fact, were we to see a continuation of the current buying push us up to the longer-term averages sooner rather than later, I’d recommend shorting stocks at that point; the easiest course to do so for most would be to take a temporary position in the Prudent Bear Fund.
However, if the major averages get above their long-term moving averages, we’ll probably see some substantial buying come in following this “confirmation” of a short-term bullish move. Institutional investors—led by pension funds hoping for a quick way out of their underfunding messes—would pile on aggressively, hoping that a big, quick move in the stock market would cure their problems. Others would join the party. Finally, individual investors will relent more, and start to shift more money back into the stock market. Once you start to hear a lot about the last of these, though, you’ll know it’s about time for YOU to take profits.
For now, I’m happy watching the better part of our stocks do well along with the overall market; some of them remarkably so, jumping substantially from recent lows, and making those of you who had the sense (and guts) to average down a lot happier. Soon, though—at the least—I hope to add a few more new recommendations among income-oriented stocks. In addition, stay tuned for a more aggressive posture if, for starters, Iraq fears diminish and, especially, if we either see stocks move above resistance or, in the alternative, hold underlying support.
to Home