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2006-06-07 :: The Fed: All Talk No Action?

The stock market has just been terrible.  No other words for it.

This week, Fed Chairman Bernanke came out with statements indicating that the Fed would continue to raise interest rates to fight inflation.  Other Fed Governors have chimed in with similar comments.  Lots of talk happening, but will it translate into action?  I have my doubts.  I still believe that we will see a 5.50% Fed Funds rate, and then a pause in the rising rates.

One of the things that the Fed has learned is that they can “talk” the market into a position without having to take any action of their own.  It sure looks like that is where we are right now.   I’m not saying that what they are doing is all bad; there is a lot of talk of Stagflation by the market pundits, based upon the Fed’s comments. 

Stagflation is the worst of all possible worlds:  rising inflation and no economic growth.  The Fed’s current posture of “talk, no action” may be the right solution for this as the threats of higher interest rates can work to keep inflation in check without having to raise interest rates significantly from here, which would quash ecomonic growth.  From a classical economic theory standpoint, you may ask how just talking about being tough on inflation can keep it in check.  The answer to that is that today’s inflationary threat is demand induced inflation as opposed to supply induced inflation.  If the Fed can dampen demand by scaring people into believing that the future is dark, then prices might be kept in check without the need to actually raise rates much more. 

Over the last few weeks, we’ve seen a big selloff in the markets, particularly in the commodity stocks as everyone fears recession or stagflation.  Fear is the key to what is happening, because the reality is not as bad as the markets have reacted.  Here are some things that I believe and that should prove true:

  • We have a bit of an uptick in inflation due to higher energy prices squeezing corporate profitability and some resulting price increases beign passed along to offset the margin squeeze
  • We cannot have rampant inflation as we did in the 70’s because China is exporting deflation based upon the falling prices of the items they export around the world
  • The Fed does not want to send the economy into a recession, particularly so soon after a new Chairman has taken the helm
  • Chairman Bernanke, in his past speaches, has focused on the risks of deflation being greater than the risks of inflation – this concern will tend to keep his interest rate increases in check
  • Absent a worldwide recession, the demand for energy, metals, and infrastructure will continue, providing secular earnings growth far greater than the rest of the market
  • Buying energy, metals, and infrastructure at these levels – if you don’t already own them – will provide you with strong outsized returns for coming years

The graph I’ve attached is of the Oil Services Index.  As you look at it, you can see that it appears we’ve double-bottomed with today’s selloff.  You can also see that we are still well above the 200 day moving average.  You can also see that this isn’t the first time we’ve seen this sort of chart pattern (and certainly it won’t be the last); Ocotober 2005 and January 2006 showed similar selloffs, base building, and bull market moves to the next new high. 

This sort of technical analysis is not my specialty, but rather I like to use it to confirm what I already know:

  • the hedge funds chase momentum, buy furiously, then panic and sell in mass
  • the momentum in the energy stocks is based upon solid fundamentals, and whenever a selloff occurs, fundamental buyers jump in to pick up stocks at near-term bottoms, waiting for confirmation of increasing earnings
  • as the momentum builds from increasing earnings, the hedge funds begin to buy furiously, pushing the stock prices up even more
  • fundamental investors then take some profits off the table (as we did in April when oil hit $75)
  • something happens to frighten the hedge funds (like the threat of reduced financial liquidity from Bank of Japan interest rate increases) and they sell as fast and furious as they can
  • fundamental investors then begin to get back into the market once they believe the fear has subsided and the cycle starts anew

We are likely in the begining stages of a similar cycle in the financial stocks as we top out the interest rate cycle.  We will begin shifting some assets into financial stocks to build an overweight position.  In an upcoming entry, I’ll let you know which companies we’ve decided to emphasize.  I can tell you, though, that it will not be the money center banks with the big exposure to derivatives…those scare me.

More later!