What Will The Fed Do?

(published a day before the FOMC meeting on January 30, 2008)

Technorati Tags: Federal Reserve,FOMC Update,Term Auction Facility

 

This emergency update on the FOMC meeting contains data that was not available at the time of release of last week's Weekend Market Review. We now strongly believe the Fed will most certainly cut the benchmark Fed funds rate again tomorrow by another 50 bps. This is in addition to the massive emergency 75bps cut announced last week.

We have a sound basis for such a bold argument. Not least because the market itself is betting on that.

 

 

There are other subtle hints as well that can be picked up by a more discerning eye. The biggest of them all is the January 25 announcement for the fourth and the last planned Term Auction Facility on January 28. The Fed started accepting bids yesterday on $30 billion of 28-day credit at a minimum bid set at 3.10%. Remember the current Fed funds rate is at 3.50% and the current rate at the discount window is 50 bps higher at 4.00%. This implies that the Fed is willing to loan reserves to member banks at the specified rate of 3.1%.

If we call our previous discussion on this topic , TAF is the discount window in a new avatar. Most of the collateral rules are the same for the TAF as for the discount window and both are processed through the twelve regional reserve banks. The only significant difference is how the rate is set. TAF involves a bidding process and is for a fixed term, while discount window is at a fixed rate. Having said that, TAF involves none of the stigma attached to the discount window ('you only borrow from the Fed when nobody is ready to lend to you').

We had hoped, rather surmised, that the TAF would succeed in bringing credit spreads back to earth. Indeed, as we have seen, credit spreads have indeed normalized since the TAF was introduced. So the exercise seems to have worked alright.

 

 

So what makes us think 50 basis points? If we look at the three auctions conducted thus far, the Fed has positioned the TAF minimum bid between its expectations of Fed funds rate and its expectation for the discount window rate. The rationale behind this is intuitive. It is implied that there should be some sort of a penalty for using a direct access to raw cash reserves directly from the central bank. But nonetheless, the penalty has to be lesser than that at the abandoned discount window.

So if the Fed keeps the Fed funds rate unchanged (3.5%) or cuts it only by 25 bps to 3.25% tomorrow, it would have effectively provided the TAF funds to member banks at a subsidy, rather than at a penalty. Remember that the Fed is a lender-of-last-resort and the TAF is pretty much its last-resort facility, with the discount window apparently not serving the purpose.

To be consistent with modern central banking practices, the Fed must cut the Fed funds rate by at least 50 basis points tomorrow. Failure to do so would be tantamount to rewriting time-tested rules of monetary policy. An event of this magnitude would further discredit this Bernanke Fed after all the criticism heaped on it over the past week. Also, excessive market volatility would be a obvious effect if the Fed stays put as investors would realize that the Fed's policy-making apparatus has become inconsistent and unpredictable... hardly what the Fed wants to do in the midst of an unrelenting credit crunch.

Further, it must set the discount rate such that it is higher than the minimum bid rate. If it does otherwise, a situation would be created where the TAF borrower would have paid a penalty above the discount rate by using the TAF instead of availing the discount window.

Lastly, the Fed would be eager to dispel the widely held belief that the emergency inter-meeting rate cut last week was prompted by the possibility of a major sell-off in the equity markets. Another 50 basis points cut would assuage fears of the Fed backstopping equity market punters as well as signal its seriousness in tackling the unraveling economy. If the Fed needed one shot at getting ahead of the curve, tomorrow is it.

Fooled By The Markets?

(Originally published on January 26, 2008)

Technorati Tags: emergency rate cut,rogue trader,Federal Reserve,SocGen,fooled by the markets,fiscal stimulus

We had signed off last week suggesting that a near term recovery may be on the cards, but just stopped short of making a decisive call. That indecision was vindicated by this week's volatile trading action. Although there was a sharp rebound in the front-line indexes from their intra-week lows, stocks had a wild ride. On the back of sharp losses in equity markets world-wide on Monday and Tuesday, front-line indexes were slated for a disastrous opening (Dow futures down 550 two hours before the opening bell). Then news trickled in of the emergency 75 bps rate cut by the Fed and futures rebounded sharply, before reflexively giving up most of their gains as traders wondered what had suddenly gotten into the Fed. After opening 350 down on the Dow, stocks gradually rallied towards the close but still ended up negative for the day. Whatever 'shock and awe' the rate cut elicited quickly disappeared. Stocks opened on a negative note again on Wednesday in line with weak cues from global markets. After trading weak for first half of the day, front-line indexes staged a dramatic rebound towards the latter half. From being down 300 at one point, Dow Jones Industrials eventually closed up 300. This was the second largest intra-day reversal ever in absolute terms, although a far 30th in terms of percentages. Stocks added onto their gains on Thursday on the back of a global equity rally and the announcement of the Bush stimulus package. Stocks opened in the green again on Friday before losing ground in the latter half of the day.

 

S&P 500 - Daily 

 

The emergency 75bps rate cut this week came with just eight days left for next week's scheduled FOMC meeting. It was the single largest reduction in lending rate since the Fed began using it as its main policy target in 1988 in the wake of the Oct 1987 stock market crash. To be exact, it was the largest single-day rate reduction since 1982 and the first inter-meeting rate cut since the central bank acted in the aftermath of the 9/11 terrorist attacks.

 

Cycles In Federal Funds Rate

A couple of weeks back, we had anticipated that an inter-meeting rate cut was certainly a possibility. We had also highlighted how the market consensus was gradually shifting towards the more aggressive 50 and 75 bps rate cuts as evidence mounted of a significant slowdown in economic activity in December. In this context, we are reminded of Bernard Baruch's words, successful speculation is about anticipating the anticipators. Although our timing was a bit skewed, the script seems to have played out just fine.

 

Dow Jones Industrials - Weekly 

 

This week's action does suggest that a possible trading bottom may have been established. Although the rate cut elicited only a delayed response in the stock markets, the medicine seems to have worked. We got to a point this week where markets became completely oversold with sentiment hitting an extreme negative. The bottoming process actually started last week, affording enough clues for us to believe that a trading bounce was overdue. The front-line indexes now look set to enter a counter-trend rally - a 5-15% rally in 2 weeks-2 months. This rally could see the S&P 500 test 1380-1410-1440 levels. Having said that, it is worthwhile to bear in mind that this will only be a trading bounce, and not a change in trend. A reasonably deep recession is possibly on the cards; recessions are usually accompanied by earnings compression and lower - often, considerably lower - stock prices. Globally, several international benchmarks have entered a technical bear market, having declined over 20% from their recent highs. Most of them, though, look set for a trading bounce.

This week, we take a preview of the proposed Bush stimulus package and whether it will actually do the economy any good. We also seek to answer whether a rogue trading scandal at one of France's largest banks could have possibly fooled the Fed into taking a hasty decision.

 

 

What Stimulus?

Hoping to give a quick adrenaline shot to the ailing economy, President Bush and House leaders struck a deal this week for a $150 billion fiscal stimulus package, including rebates for most tax filers of up to $600 for individuals, $1,200 for couples and, for families, an additional $300 a child. The deal capped a series of fast-paced and intense negotiations, in which the Bush administration and lawmakers in both parties agreed to numerous compromises after more than a year of acid relations. While efforts to provide a stimulus to the economy are laudable, any such legislation will only further add to our soaring fiscal deficit. So it is of utmost importance that we get as much 'bang for the buck' as possible.

Although the package includes a reasonably designed tax rebate, the two most targeted and economically effective measures under consideration - a temporary extension of unemployment benefits and a temporary boost in food stamp benefits - were zeroed out, apparently at the insistence of House Republican leaders. Moody's Economy.com estimates that for each dollar spent on extended UI benefits, $1.64 in increased economic activity would be generated. Increased food stamp benefits would generate new economic activity worth $1.73 per dollar spent. No other options rated as high. Further, every dollar in 'accelerated depreciation' - the principal tax cut in the package - would result in only 27 cents of increased economic activity. A 2006 joint study by the Congressional Budget Office and the Federal Reserve indicated that business tax cuts adopted in the last recession, that closely resemble those in the current package, had only modest stimulative effects. The business tax cuts also would cause states to lose at least $4 billion in state revenue, due to linkages between Federal and state tax codes. The proposal does not include any relief measures for the states. Consequently, many states could enact deeper and more painful budget cuts, acting as a drag on the economy.

On the positive side, the reasonably designed tax rebates are vastly superior to the earlier proposals mooted by the administration, under which more than 25 million low and moderate income working families would have been shut out. Most of those families would get a substantial rebate under the new package. Nevertheless, the rebates for working-poor families (who will spend, rather than save, the largest share of their rebate dollars) will apparently be smaller than those for middle and upper middle-income families.

Standard economic theory propounded by Milton Friedman suggests that for stimulus funds to be spent, they should go to people in temporary economic difficulty who are likely to be liquidity-constrained. But most of the measures that would have done just that appear to have been bargained away. Even the tax credits are apparently not fully refundable, so those who need it the most, and are most likely to spend it, will probably not get the full amount. But any stimulus plan, even if poorly designed, is probably better than no stimulus at all. Not enacting a stimulus package would leave the entire recession-fighting to the Fed and as we have pointed out below, the Fed may be running out of ammunition. As shown in the table below, lawmakers have a penchant for enacting stimulative legislations at the fag end of recession and the early stages of a recovery, thereby completely missing the point. With the added election incentives this year, we hope Congress can put together a package as speedily as it can.

 

 

 

Another Rogue Trader

The rogue trader's elite community had a new entrant this week : 31-year-old Jerome Kerviel. In one of the most unsettling disclosures in the banking industry in recent memory, Société Générale, France's second largest bank, announced that the rogue trader had made unauthorized bets on stock index futures, costing the bank I €4.9 billion ($7.2 billion), the largest trading loss in banking history. To put the figure in perspective : this loss exceeds the $6.6 billion Amaranth Advisors LLC lost in 2006 and is more than four times the $1.4 billion of losses piled up by Nick Leeson that brought down Barings Plc in 1995. SocGen now plans to raise €5.5 billion from its shareholders after the loss and large sub-prime related write-downs significantly depleted capital. The Bank of France, the country's banking regulator, is investigating the alleged fraud.

A letter by the Chairman posted on the company website indicates that the transactions were simple but were hidden through extremely sophisticated techniques. Kerviel used his intimate knowledge of the bank's risk control systems ('breached five levels of controls' - Christian Noyer, Governor, Bank of France) to build a massive long position on European stock index futures, amounting to some $73 billion. The trades were massively in the money by end-2007, but had started bleeding losses when the equity markets dived starting this month.

Société Générale has a reputation for its expertise in equity derivatives which has become a big money spinner for it. Risk Magazine has ranked it first or second during the past five years in client surveys of equity derivative firms. It earned the ‘Equity Derivatives House Of The Year’ tag from both RISK magazine and Banker, a London-based monthly magazine.

The accident highlights how vulnerable bank's security controls still are and how an insider with sufficient knowledge of the systems can still create havoc. Kerviel is no trading legend who let a transaction get out of hand. He was a low-level trader in the bank's ‘Delta One’ desk in western Paris, earning about €100,000 ($145,000) a year. Clearly, banks are yet to learn their lessons from 13 years ago, when a single trader by the name of Nick Leeson brought down a 233-year old British bank.

 

 

Fooled By The Markets?

Details of this incident sparked speculation that the selling by SocGen, estimated to be 10% of market trades, caused the massive downside volatility earlier in the week. It is now apparent that the European Central Bank knew early on about the problems at SocGen, but the Fed apparently was caught napping. 

Some serious questions are now being asked. Was the Fed duped into a clumsy and panicked move by a cleanup operation at a French bank? Why did their French and ECB counterparts not tell the Fed about the happenings at SocGen? What was the motivation for an aggressive rate cut just seven days before a scheduled FOMC meeting?

We are on record in suggesting that the Fed has been largely behind the curve for much of last year. We have also suggested that the increasing gloom about the economy warrants an aggressive easing in monetary policy. But the timing here is baffling. Slashing rates with such aggression a little over a week before a scheduled meeting, smacks of panic. 'Downside risks to growth' surely exist; but the economy had not grown any weaker over a long weekend. Considering the inherent delay before changes in monetary policy affect spending, the sudden urgency seems odd. 

It is hard not to conclude from this sudden change of tack that the Fed acted mainly to shore up markets, which had alarmingly switched to panic mode in just a week. Indeed, the Fed noted that 'financial market conditions have continued to deteriorate'. Were the equity markets not functioning properly? Globally, equity markets are in a process of re-pricing risk and lofty valuations after a long bull market amidst an increasingly likely possibility of a concurrent US, European and Asian economic slowdown. Why should the Fed try to disrupt a market-based process of wringing out some excesses out of the system through a healthy capitulation? With Fed funds already at 4.25% before the cut, it would be fair to say that the Fed decided to use its limited ammunition to intervene, nay guarantee, equity prices. The Fed is charged with keeping employment high and inflation low, not back-stopping equity market punters. 

To be fair, the Fed may just be using equity prices, as many economic analysts do, as a useful aggregator of private and public information about near term prospects for economic growth. With all recent indicators suggest a significant deterioration in real economic activity over the past two months, a recession may be already upon us. Just as the 50 bps cut in April 2001 failed to prevent a recession, this one may fail as well. Bernanke probably simply intends to do what he can to mitigate the damage. But the action is so disproportionate (the sudden change in tack) and ill-timed that it will only further unsettle markets. With people pondering 'What does the Fed know?', we believe this action has only strengthened wide-spread belief that a recession has already begun.

The reactions in the past week have polarized the financial world. While the emergency rate cut was cheered on by some sections, others rightly have jeered. Bill Gross, manager of the world's largest bond fund, quipped that it is a sad state of affairs when the Fed has to cut interest rates just eight days ahead of a meeting to salvage equity markets. Barry Ritholtz, widely read blogger, columnist and a respected voice in financial media, remarked that the panicked rate cut would prove to be an historical embarrassment and that the Fed allowed itself to be bossed around by futures traders. 

The markets initially failed to view looser monetary policy and cheaper money as a nice surprise. Dow futures traded down over 550 points on Tuesday morning before the markets opened; after a gradual recovery through the day, the indexes finally closed down 'only' 128 points. Although the indexes rebounded strongly thereafter, we have a lingering suspicion that all the Fed may have achieved this week is merely delay the inevitable.

Another Dreadful Week

(originally published on January 19, 2008)

Technorati Tags: Baltic Dry Freight Index,fiscal stimulus,Put-Call ratio,VIX,write-down

 

Stocks had another awful week, dropping between 4-5% for the week. The broad-based S&P 500 slumped 5.4% this week, its biggest weekly decline in five years. Last week, we had compared the stock markets to a chronic alcoholic who has had frequent unsuccessful visits to Alcoholic Anonymous; as time goes by, his addiction gets stronger and it becomes increasingly difficult to wean him away. Even the announcement of a major fiscal stimulus package this week failed to evoke any significant response from the bulls.

 

S&P 500 - Daily Chart

The front-line indexes are now trading well below their summer lows and are a long way off their recent highs. The S&P 500 is down 15.9% from its October highs; the Nasdaq Composite on the other hand is on the verge of entering a full-blown bear market, having declined over 18% from recent highs. As shown in the table below, a decline of this magnitude has heralded greater downside in previous bear markets.

 

 

Only 11% of the S&P 500 stocks are now above their 50 day moving averages. In hindsight, the rally off the summer lows was rather feeble and lacked the conviction typical of a bull market. To further prove our point, take a look at the chart below from Bespoke Investment Group that compares the daily breadth in the S&P 500 stocks with its daily % change. Since 2003, there have been only six days where the S&P 500 advanced more than 1% with a breadth of under 250, i.e. only half of the 500 stocks rose on these days. Four of these six days have come since August 2007.

 

Scatter plot of daily breadth of the S&P 500 versus daily percentage change (2003-2008)

In the face of a relentless decline since the beginning of the year, volatility is now beginning to pick up. Nine out of the 13 trading days this year have seen a daily closing change in S&P 500 in excess of 1%. The 50-day average trading range for the S&P 500 is at 1.68% - its highest since early 2003. The VIX, a measure of expected 30-day volatility, shot up this week after a prolonged lull, suggesting that fear is setting in the minds of market participants, albeit much later than the 2007 summer panic meltdown. Bear markets are typified by slow grinding downtrends, as traders get accustomed to the idea of daily declines.

 

Comparison of S&P 500 and VIX : Volatility gradually creeping up

 

On the other hand, the unrelenting market-wide selling pressure is now pushing stocks into oversold territory. Out of 71 technology stocks in the S&P 500, all but two have seen YTD declines. Only four of these stocks are above their 50 day moving averages. The Put-Call ratio, one of our favorite contrarian indicators, spiked up this week, surpassing its 3-sigma 99.73% confidence level for the first time since August of last year. With several stocks now deeply oversold, we would advocate booking some profits at these levels. A pullback to possibly 1360-1370 levels on the S&P 500 would provide an attractive entry point for fresh short positions.

 

Comparison of S&P 500 and Put Call Ratio: PCR crossed its 3-sigma level this week

The last two weeks have been anything but dry. But the Baltic Dry Freight index ended down almost 25% in just a week. The index, a widely recognized leading indicator of global economic activity, is now down 37% from its mid-November peak. This is a significant development that could possibly rebuff the entire global decoupling hypothesis. The economic releases this week were mostly negative. The Conference Board's index of leading economic indicators dropped 0.2% in December, its third consecutive drop. Consumer prices rose 0.3% in December, receding from the scorching 0.8% gain in November. For whole of 2007, headline inflation has risen 4.1%, the most since 1990. Housing starts declined 14% in December to an annual rate of 1.006 million, the lowest since 1991. Starts registered a 25% decline in 2007, the biggest since 1980.

The market continues to reel under the weight of massive write-downs. Merrill announced a $16.7 billion write-down in its 4Q results, while Citigroup did even better with a $18.1 billion write-down along with a cut in its dividend. This is most certainly the worst quarter ever for investment banks.

 

Tally of write-downs by investment banks (as of January 19, 2008)

 

While the economy continues to spiral towards a recession, the concerted central bank efforts to thaw the credit market freeze seem to have worked. The TED spread - the spread between three-month LIBOR and Treasuries of the same duration - is at its lowest since August 13. The 3-month LIBOR rate is now below the Fed funds rate for the first time since June 2003.

 

Spread between three-month treasuries and three-month LIBOR

The sixth century Chinese poet Lao Tzu penned that those who have knowledge do not predict, while those who predict do not have knowledge. After a vicious decline, a near-term oversold rally looks on the cards. But we have to side with Lao here; in view of significant bearish headwinds mentioned above, we would defer a bullish prediction for now.

A Shot In The Arm??

(originally published on January 19, 2008)

Technorati Tags: fiscal stimulus,recession,inflationary expectations,rebates

 

With consensus forecasts rapidly veering towards a recessionary outcome, calls for some sort of a fiscal stimulus have gathered steam of late... not least because of the posturing by the contesting Presidential hopefuls. Describing it as the 'most pressing economic priority', President Bush announced a growth package that would amount to as much as 1% of the nation's GDP, or about $140-$150 billion, and would be 'big enough to make a difference'. Although specifics on the stimulus plan were not offered, media reports suggest that the administration is considering offering $800 tax rebates for individuals and $1600 for households. The package could create a half million jobs this year. The plan is likely to be temporary, without any tax increases and separate from the Republican idea of making the Bush tax cuts permanent.

The White House and the Congress are said to be keen on hammering out an agreement quickly, with some Democrats saying it could come in 30-45 days. With neither party enthused with the prospect of facing voters in the midst of a recession, legislative progress seems quite plausible. However, what is more difficult to discern is whether the entire exercise is actually justified.

With that in mind, we evaluate in the next few paragraphs whether such a proposal makes economic sense. We take guidance from history, notably the Bush tax cuts during the last recession, in gauging the potential risks and rewards of such an exercise.

 

Do We Really Need It??

It is no secret that the economy is slowing. The scales have tilted in favor of a recession in the eyes of several economists, especially following the latest employment report . Some like Bill Gross have even suggested that we may already be in a recession. Even if there is no officially defined recession a significant slowdown in the economy is a near certainty that will nevertheless feel like a recession in many parts of the country and to many businesses and families.

The Federal Reserve has done its bit to stimulate spending by cutting interest rates and trying to ease monetary and credit conditions. Having said that, there is enough room to cut rates further; the current federal funds target rate is 4.25%, well above the 1% target maintained in 2003-2004 to support the recovery following the 2001 recession. Also, as the CBO director Peter Orszag noted recently, historically fiscal stimulus packages have often been 'poorly timed or designed in relatively ineffective way' to do much good in a recession. The Fed, on the other hand, is likely to be more adept at fine-tuning monetary policy to maneuver the economy through muddy waters.

Further, as the economy decelerates, slower growth of income, payrolls and profits causes tax receipts to dip relative to spending. Simultaneously, outlays on programs such as unemployment insurance and Food Stamps rise. This combination temporarily boosts demand for goods and services, thereby helping to offset some of the weakness in demand. The CBO estimates that, since 1968, these so-called 'automatic stabilizers' have added between 1-2.5% of GDP to the deficit during recessions, translating to about $140-$350 billion in today's terms.

Having said this, the case for a fiscal stimulus is strong. The recovery from the 2001 recession has been weak by historical standards. The latest employment report showed that job growth screeched to a halt in December with only 18,000 jobs added overall, an actual decline of 13,000 jobs in the private sector and a sharp jump in the unemployment rate to over 5%. Although real economic growth rocketed along in 2Q and 3Q of 2007 (3.8% and 4.9% respectively), near-term projections are for the economy to grow at a much slower pace, in the face of ongoing adjustments in the housing market, declining consumer spending and stubbornly high oil prices. There is also a risk that financial markets could turn on its back due to the spreading of the sub-prime contagion.

 

So, What Should Be The Nature Of The Stimulus??

Fiscal stimulus is aimed at boosting economic activity by raising short term aggregate demand to engage more of the nation's existing productive capacity. This is in contrast to traditional policies that are designed to improve long term economic growth by increasing the total productive capacity. Short-term demand-focused stimulus operates on a set of principles that is frequently at odds with the underlying long-term supply-based policies. Demand may be increased directly, as in the case of direct government spending on goods and services, or may have happen indirectly, by raising household consumption or business investment. Household consumption is generally stimulated when either after-tax income or expected lifetime wealth increases as a result of either reduction of taxes or increase in transfer payments from the government. Business investment can be stimulated by sufficiently boosting the after-tax return on capital to make additional investment profitable.

But as is the case with any potent medicine, a stimulus if mis-administered could actually end up doing more harm than good. So what should such a package comprise of? Most economists agree that the characteristics of a sensible fiscal stimulus should confirm to the three Ts : timely, targeted and temporary. Timely measures are those that, once triggered, stimulate new spending quickly so that businesses do not have to cut back on production or lay off workers due to weak demand. Simple measures such as tax refunds or enhanced benefits work most effectively obviating the need to devise new programs that could see delays in implementation. The package should be designed in such a manner that the funds would be targeted where they are most in need and to those who are most likely to spend the bulk of the new resource provided to them. Tax cuts that mainly benefit high-income individuals are a poor choice to provide stimulus, because those individuals are more likely to save a large share of any increase in disposable income they receive than are people of more modest means. The stimulus should also be temporary, so as to not hamper the country's long term fiscal position. If this maxim is not followed, stimulus could persist even after the economy recovers and policymakers run the risk of a bout of inflation, high long term interest rates and higher capital costs. If fiscal credibility is to be maintained, it is equally important that no measure be enacted on a temporary basis that will at a later date generate overwhelming political pressure for an extension.

It is often assumed that tax cuts are inherently stimulative, while spending increases are inherently less desirable as an economic stimulus. However, as pointed out by Nobel laureates Joseph Stiglitz and Peter Orszag in 2001, both spending increases and tax cuts can be as effective - or ineffective - as a stimulus, depending on their nature and design. Increases in government spending tend to have a greater stimulative effect as more of such an increase translates quickly into an increase in total spending in the economy, as compared to tax cuts where a substantial part is generally saved.

 

Comparison of the impact of various fiscal stimulus measures

 

But Are There Any Risks??

The balance of risks facing the economy is now clearly on the side of recession rather than inflation, as admitted even by the Fed recently. Even as fuel prices continue to surge, core prices have remained under check. Inflation as measured by the Fed's preferred personal consumption expenditure index, excluding food and energy, rose 1.9% over the last year, within the Fed's comfort range. Measures of inflationary expectations as inferred from the Treasury Inflation Protected Securities (TIPS) are close to their lowest point in the last two years.

Besides inflation, the other major risk is that of timing. The major drawback with past fiscal interventions has been that the stimulus has come too late. Conventional wisdom recognizes two types of lags - inside lag, the time between recognition of a problem and action and outside lag, the time between action and the resultant impact. For monetary policy, inside lag is short, while outside lag is longer. The reverse is true for fiscal policy. Spending, and associated multiplier effects of spending, can usually be effected fairly rapidly. With the Congress seemingly in a hurry to push through some legislative action, any inside lag can also be whittled down.

 

Will It Work??

In our opinion, the looming possibility of a recession (and a major one at that) warrants fiscal stimulus, on top of the one that monetary policy can provide. Calculations by Douglas Elmendorf of the Brookings Institution suggest that a temporary tax rebate worth $100 billion could boost the annualized rate of GDP growth by between 0.8 and 3 percentage points in the quarter in which it was enacted. A study published last year on the 2001 tax rebates found two-thirds of the money was spent within six months of receiving it. In contrast, monetary easing, in the form of interest rate cuts, can take a year or more to have an impact. Counter-cyclical measures can provide the economy a significant shot in the arm.

Having said that, it is important that concerns over a possible recession in the short term are not used to justify fiscally irresponsible measures that could exacerbate the nation's already serious long-term fiscal problems. Any plan should be intended to provide additional cost-effective short-run stimulus on top of the one that monetary policy can provide. The decidedly mixed historical record of fiscal stimulus actions in the past should also be taken into consideration. But it is still likely to serve its intended purpose. Even if it fails to avert a recession, it should certainly help reduce the severity of one.

Bears Gain An Upper Hand

(originally published on January 12, 2008)

Technorati Tags: earnings,Fed-speak,January barometer,sectoral returns,Hooper indicator

 

We had questioned last week whether 2008 would turn out to be the 'Year of the Bear' in the stock markets considering the lurking full-blown recession in the horizon. We had also concluded that a 50 bps rate cut seemed a certainty at the upcoming FOMC meeting.

The events that unfolded this week confirmed most of our contentions. Sentiments were battered following last week's thrashing. After enduring a nervous session on Monday due to the resurgence of some hostilities with Iran, stocks declined sharply on Tuesday following disappointing pending home sales data and rumors of Countrywide filing for bankruptcy. Stocks, however, rebounded sharply from their intra-day lows on Wednesday driven by an upbeat profit forecast from Dow component Dupont and the stepping down of Bear Stearns bridge-and-golf-playing chief executive Jimmy Cayne. A stronger-than-expected earnings announcement from another Dow component Alcoa and Bernanke's speech hinting towards further aggressive rate cuts lifted spirits up briefly, fueling strong gains on Thursday. The most notable gainer for the day was Countrywide Financial which shot up over 50% in a sudden intraday spike following rumors of Bank of America agreeing to acquire the struggling mortgage lender. The gains were however, short-lived, with stocks resuming their descent on Friday following reports of Merrill Lynch writing down an additional massive $15 billion and American Express increasing its loan loss reserves to cover increased customer defaults.

 

S&P 500 - Daily

 

Most stocks ended the week lower - the third straight weekly decline - with majority of the losses witnessed in the higher beta Nasdaq indexes and the small and mid cap laden Russell 2000. The Dow Jones Industrials, S&P 500 and Nasdaq Composite are now well and truly below their summer closing lows.

 

Dow Jones Industrials - Daily Line Chart

 

All the frontline indexes are way below their October highs and some are on the verge of breaking down below their entire 2007 trading ranges. In this period, the utilities have expectedly shown a clear out-performance, while the financials have lagged miserably behind.

 

Comparison of sectoral returns from their respective October 2007 highs

 

While the S&P 500 is now around 12% from its intra-day highs in October, individual stocks are taking it much harder on the chin. As seen in the chart below, the average stock in the S&P 1500 universe is down over 30% from its 52 week highs, with small cap stocks faring a lot worse than their large cap counterparts.

 

Average distance from respective 52-week highs for stocks in S&P 1500

 

The stock market clearly has got off to a bad start in 2008 and the bears are understandably circling the hapless bulls. Already, the Dow Jones Industrials and S&P 500 are down 4.9% and 4.6% respectively YTD while Nasdaq 100 and Russell 2000 are down 8% each. Year of the Bear?? The stock markets are now behaving like a chronic alcoholic who has had frequent unsuccessful visits to Alcoholics Anonymous over the past few months. With time, it becomes increasingly difficult to wean the alcoholic away from his addiction. With time, it has become increasingly difficult for bulls to muster up the strength to stage a recovery. The good news gets discounted instantly, while the bad news is brooded over. In such a scenario, forecasting far out into the year is a tricky exercise indeed. Nevertheless, we look back at some historical statistics, that indicate how January has set the tone for the rest of the year. With earnings season getting busy next week, we also try to figure out what could lie in store on that front. We finally conclude with some Fed-speak that hogged the headlines this week and try to unearth some clues from them.

How Do The Stats Stack Up??

(originally published on January 12, 2008)

Technorati Tags: statistics,January barometer,Hooper indicator,election year

 

Old timers on Wall Street would probably have come across market historian Yale Hirsch's phrase, 'as goes January, so goes rest of the year'. Statistics seem to back up this catchy slogan. In 46 of the past 58 years since 1950, the S&P 500's year-end finish mirrored how it fared in the first month of the year. Even in 2007, stocks gained a modest 1.4% in January, with the year end tally being up 3.5%. Every down January on the S&P since 1950 without exception preceded a new or extended bear market, or a flat year. According to research done by Sam Stowall, S&P's chief investment strategist, a hypothetical portfolio of the 10 best-performing S&P industries in January has beaten the overall S&P 500 in the remaining 11 months of the year 75 percent of the time since 1970.

 

 

Lucien Hooper, a Forbes columnist, noted back in the 1970s that whenever the Dow Jones Industrials broke below its December closing low in the first quarter of the next year, it frequently acted as an excellent warning sign for more trouble ahead. All but one of the 27 such instances since 1952 has witnessed further declines, with the Dow falling an additional 10.5% on average. Only three significant drops occurred when the December low was not breached in Q1 (1974, 1981, 1987).

 

 

Quirky market indicators need to necessarily be taken with a fistful of salt. Nevertheless there is no denying that a weak January becomes a psychological negative that weighs on stocks for the rest of the year. Events in January tend to set up things for the rest of the year. It is an uphill battle akin to a football team falling behind by two touchdowns in the first quarter of the Super Bowl. By that token, the statistics shown above seem formidable. However, there is one statistic in favor of bulls that deserves a mention. Since 1949, election years have been lopsidedly bullish with an average gain of 9.3% and only two negative years (1960 and 2000). It will be interesting to see how this election year shapes up.

All Eyes On The Earnings

(originally published on January 12, 2008)

Technorati Tags: earnings,financials

 

We are now firmly into the earnings season. The next three weeks will see the bulk of corporate America report their 2007 year-end results. From where we sit, it sure does not look good. Earnings estimates have taken a remarkable hit in the past few weeks. At the start of 4Q, analysts estimated S&P 500 stocks to report an earnings growth rate of 11.5%. That has of course now changed. Thomson Financial estimates that blended S&P 500 earnings, combining actual numbers for companies that have reported and consensus estimates for companies yet to report, is likely to have declined 11.3% in 4Q, largely driven by mammoth downward revisions in Financials. This is the wildest swing in estimates within a quarter, ever since Reuters began compiling them in 1999.

 

 

 

However, if one were to exclude the Financials from this tally, the earnings picture looks a lot better. On this basis, cumulative earnings ex-Financials could be expected to increase 12%, in line with forecasts issued in early October. Utilities, Energy, Technology and Telecom are all expected to have notched up earnings growth of 15% or more in 4Q. All sectors except Financials are expected to notch up positive earnings growth in each quarter of 2008. Nonetheless the unrelenting weakness in Financials has turned overall sentiment bearish heading into the thick of the earnings season. On a slightly contrarian note, this excess negativity could actually turn out to be bullish for the broader markets if the other sectors report inline or better than expectations. It will certainly be interesting to see how the earnings season shapes up.

 

Too Little, Too Late??

(originally published on January 12, 2008)

Technorati Tags: Fed-speak,FOMC meeting,inflation

 

In an unusually blunt speech to a business group in Washington this week, Fed Chairman Ben Bernanke hinted that the economic outlook had indeed taken a turn for the worse into the new year. He noted that 'the baseline outlook for real activity in 2008 has worsened and the downside risks to growth are now more pronounced', effectively rewriting the Dec 11 FOMC statement. This marked shift may possibly have been driven by last week's Labor Department report that showed that the jobless rate jumped to 5% in December and the first decline in private sector employment since 2003. Bernanke pledged that the Fed stood 'ready to take substantive additional action' and 'provide adequate insurance against downside risks'.

Similar sentiments were echoed this week by other Fed speakers as well. Fed Governor, Frederic Mishkin, a former collaborator with Bernanke on academic research, suggested that 'waiting too long to ease policy... might well increase the overall amount of easing that would eventually be needed'. Philadelphia Fed Bank President Charles Prosser, who is considered by economists as the toughest on inflation, moderated his stance this week, hinting that slumping consumer spending is his biggest concern at the moment.

The consensus has now solidly shifted toward a 50 bps rate cut as shown by the chart from the Cleveland Fed below. Fed funds futures contracts traded on the CBOT suggest that the odds of a 75 bps rate cut this month jumped to 43% from virtually zero earlier in the week, suggesting that some traders at least see the chance of a move before the FOMC meeting.

 

Implied probabilities of different outcomes of January 30 FOMC meeting (as of January 19)

 

Why is this change of heart from the Fed significant? Is it significant at all? Bernanke has generally sought to avoid front-running the committee. By that token, such an aggressive message suggests that there has been some committee-wide communication in the past few days. The Fed seemed to have underestimated the magnitude of the credit shock and its subsequent fallout. Its monetary policy stance 'appeared to somewhat restrictive', as admitted in the minutes of the Dec 11 meeting released last week. Despite denying that his models indicate a recession in the making - the politically correct thing to say - the Fed chairman may now be worried that his worst fears are indeed coming true. The 14-page speech contained just a single paragraph on inflation and even that seemed to downplay the threat of inflation against the larger evil of slowing growth, signaling a resolution to the long-standing debate over the competing risks of slower growth and faster inflation. By stating that monetary policy remains the Fed's best tool for pursuing its macroeconomic objectives, Bernanke has primed the market for a 50 bps rate cut when the FOMC meets later this month while also keeping the possibility of a inter-meeting rate cut open even as it pursues the other tools in its arsenal such as the Term Auction Facility.

 

Comparison of Fed Funds rate, Unemployment and inflation

 

As shown in the chart above, it is not unusual for inflation to be rising moderately as the Fed embarks on a rate cutting spree in response to faltering growth (brief period of stagflation). The weakening economy usually takes care of the inflation. This is what the Fed is now betting on. But could inflation be a bit more persistent this time? Import prices rose by 10.9% in 2007, the biggest calendar-year increase since 1987. Data released this week indicated that US trade deficit in November widened to $63.1 billion, its most in two years, driven by a phenomenal surge in oil prices, overshadowing record levels of exports that have been driven by a weaker dollar and growing demand from Asia and Latin America. Back-of-the-envelope calculations suggest that the average price of oil in 2007 would be around $65. A sustained $90 and above price of oil in 2008 would inflate that trade deficit by another $100 billion. Resurgence of tensions with Iran this week provide further supply side shocks that could keep the ground for oil fertile in 2008 as well.

The Fed found itself stuck between a rock and a hard place and bravely decided to lean towards the side that hurts less. Bernanke is a smart man... he sure realizes the options before him. The economy suffers from not just illiquidity, but also insolvency, which cannot be resolved with monetary policy alone. In its dance of denial, the Fed has remained behind the curve for over a year in its mistaken assessment of the risks of a recession. The aggressive Fed easing now will only limit the depth and extent of a recession; it will in all probability fail to prevent it. Further, inflation concerns aside, the risk of a dollar free-fall and the risk of foreigners pulling the plug on the external financing of the nation's burgeoning current account deficit will limit how much the Fed can ease. When the economy is grappling with a glut like now (glut in housing, autos, consumer durables sectors etc., similar to the glut of tech capital goods in 2001), pushing more money into the system is akin to pushing on a string.

Markets have rallied every time the Fed eased and/or suggested further rate cuts. But these rallies seem to be running out of steam and are becoming increasingly short-lived. Bernanke's speech this week met with only a tepid response. Like 2001, a full fledged bear market might get underway when investors at large realize that the Fed easing will not prevent a recession. As the popular pop song goes, it may just be a case of 'too little too late'!