Looking Past the Slowdown to the Green On the Other Side

By Dr. Duru written for One-Twenty

September 21, 2006

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Looks like the Fed is still not done being done with interest rate hikes. Yesterday, the Fed delivered a very familiar statement telling us that it expects inflation pressures to moderate aloing with a slowing economy. The Fed is also trying to keep the market on its toes with the reminder that it could still decide to raise rates again at any time if the data commands such an action. The market has clearly chosen to focus on the rose and look past the thorns. Amazingly enough, I am increasingly reading and hearing expectations for rate cuts in 2007. Let's take a closer look at the logic that is working to maintain strong bids in the current market....

  1. The economy is slowing down. Housing is in a slump and will drag or is dragging the economy down. The bulls are counting on this to justify optimism for rate cuts next year. The bears are counting on this to vindicate expectations of an economic collapse. Currently, consumer spending remains relatively strong.
  2. The prices of oil, commodities - almost everything we consume to produce and deliver goods - are falling, heck crashing (yet another bubble gone? And just in time for November elections? Hmmm....). The bulls are counting on this to justify expectations for low inflation. I suppose the bears are crying over gold and silver, but they can take solace in the expectation that crashing commodities signal a coming crash in demand in the economy. Note that the bond market remains unfazed by inflation prospects. The 10-year bond is back under the Fed funds rate and is resting quite happily there.
  3. Once the economy slows down enough - euphemism for a "near-crash" in housing - the Fed will be forced to cut rates. The bulls are counting on this...shoot..I cannot explain it. The bears believe it but expect a reactionary Fed to re-ignite inflationary pressures in the economy at best, or the "near-crash" will tank the economy at worst.
  4. In conclusion, the bulls say, buy equities because the economy is going to slow down just enough to get us cheaper money, but without the pain of a recession. This is sure hoping for a lot, right? First of all, the overall economy has not even slowed down much yet. For example, unemployment is still scratching at historical lows. So, times are pretty good now, and I am supposed to buy stocks ahead of a slowdown? Certainly. Just look beyond the coming slowdown, over there where the grass is greener...that is where the economy rebounds, snaps back even, as the Fed cuts rates to soften the blow. The market is a dicounting mechanism, but that sure sounds like some deep, deep discounting to me!
  5. Alternate conclusion: the economy is not going to slow down further, even if housing continues to slide further into the doldrums. Buy stocks now because growth is just fine now and will continue to do so...and assume the Fed will continue to stand aside as well. The risk with that scenario is that with every passing meeting that is not greeted with a notable slowdown in economic activity, the Fed's anxiety is bound to increase...and so will interest rates.
This sounds like one big mess to me. And it sure explains why no consensus seems to exist out there amongst the pundits about how to assess all these prospects. In fact, I have heard and read some very strong opinions all over the map. Of course, the market has already voted by cotninuing to send stocks higher and maintaining low bond yields. As you know, I have already voted for the stagflation interpreation where economic growth slows down and prices remain high (I usually refer to it as "slow growth, persistent inflation" to avoid direct comparisons to the economic horrors of the 1970s). However, if commodities keep sinking, I will be forced to expect a plain ol' vanilla economic slowdown. Inflation cannot hang around when two big booms are tumbling down into a deflationary bust: housing and commodities. And if corporations continue to hoarde the lion's share of the boom in profits, instead of allowing more of the largesse to trickle down into significant wage gains, inflation will even more likely live up to the flowery forecasts of the many who are not worried about it. Finally, the slowdown side of the claim goes belly up if the housing market somehow recovers "early." In fact, more and more folks are making elaborate cases for a bottom in the stocks of homebuilders. I will have to weigh in at some point given my short-lived attempt to call for a bottom earlier this year.

I also voted for some kind of correction by the end of September or early October. The prediction business is a hard game and a merciless taskmaster. (I really try not to do predictions, but they are so often a good tool for describing and illustrating my current frame of mind). It seems the bullish interpretations described above have enough supporters to sustain good buying power in the financial markets for now. The sharp downward shift in sentiment in the commodities markets is sending fresh cash into other equities - both defensive and growth (tech) stocks. Seeing both defensive and growth stocks rally strong here further confirms the sharp dichotomy in opinion on what's going on in the economy. I still maintain that this bull market is getting more and more tired with every rally. I look forward to revisiting this analysis at the next big move or high in the market (or the next air pocket!).

Be careful out there!

DrDuru, 2006