Playing Chicken With the Fed
April 17, 2005
How low can we go? My man, Mike, has an excellent summary of just how ugly things have gotten in the markets now. I am particularly surprised that the S&P 500 did not survive the test of its 200DMA. In "typical" panic sell-offs, the S&P has been the last to hit this oh-so-important long-term support for bullishness…and when that test succeeds with buying interest, it pulls the rest of the market back up with hope and good cheer. I have also been claiming that we should get about two weeks of rally out of this earnings season. The bulk of earnings season is happening in the next two weeks, so if my theory is to hold any water, the previous two weeks of pessimism must give way to a pretty vigorous rally starting this week. I will re-emphasize Mike's point though…catch all the falling knives you want, but this market is stinking up the joint really bad…the bias is to the downside…big-time. The bear is growling loud and strong.
Mike has said that it feels like the market fears something big is about to hit us. This kind of selling tells me that the market fears recession. However, the Fed has said nothing about economic weakness. In fact, they are preparing to cool down what they see as a looming threat of an economy getting a little bit ahead of itself. I find it extremely ironic that the market actually rallied when the Fed bared its teeth and drew its sword during the latest round of Fed-mania. The short-lived optimism that came from misinterpreting the Fed minutes has no doubt made the current selling even worse. There are still a lot of folks who agree with the Fed that the economy is just fine, and the longer they continue to buy for bottoms, the longer we wait for a real bottom.
The market is in a mode of playing chicken with the Fed. It is essentially screaming out for the Fed to cease and desist from its campaign to stomp out inflation. The Fed will have an extremely hard time talking about economic strength and inflation while the market deflates before its very eyes. The market does not know how far down it must go, or how much pain it must inflict, to get the Fed to back down, but it is going to do its best. The worst thing about the box the Fed has created for itself is that all this market weakness is driving long-term interest rates down again. Investors and traders are fleeing for the relative safety of Treasuries as they anticipate future economic weakness. The Fed wants higher rates to fight inflation and squash speculative frenzy. With this in mind, the housing sector must be the specific target because there is almost nothing else working well in the current economy. But now these stubbornly low rates will only further support the lofty levels of the housing market (I am being economically correct in avoiding the term "bubble"!). If the Fed backs down from its current campaign, they will leave an economy disturbingly teetering on its own over-sized leverage. They will signal to the consumers that spending remains better than saving, speculating on housing remains better than investing, and corporations will become even more uncertain given the apparent capricious nature of the Fed. The Fed seemingly has no choice but to press on with rate hikes. Perhaps they can clearly communicate some sort of cap, but they will loathe binding themselves even more. If poor Greenspan was befuddled by the persistence of low long-term interest rates, he is probably going to break out into a cold sweat now! (This is what he said to the Committee on Banking, Housing, and Urban Affairs, U.S. Senate on February 16, 2005: "The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.")
None of this weakness should come as a surprise to us. We began the year with these very same fears of a suddenly unfriendly Fed. The market sold off the new year with force once it got its first taste of the "new" Fed. But the Fed also made plenty of deflationary comments back then to send the market into manic mode for 2005. We watched in horror as the market careened quickly wiping out all the green from 2004 and then some over the first 3 weeks or so of the year. We watched in glee as relief from earnings bounced the market to challenge 52-week highs. And now we watch in renewed horror as the market has spent the last 6 weeks or so grinding its way down to new lows for the year. We have even given back ALL of the post-election cheer that sent the indices hurtling upward. Can the 2004 lows be all that far behind? One thing seems clear, the decade-long trading range that I have spoken about is still in full-effect. Buying when all seems well is still a money-losing proposition. By my count, I still have another five years of warning you to…be careful out there!