Tough Decision for the Fed

Today is the much anticipated release of the Federal Open Market Committee minutes. This is an exceptionally difficult decision for the Fed. The market has already discounted another quarter point decline in the fed funds rate, so even if they do drop the rate the market may sell off anyway. Neither the market nor the economy got much of a boost from the September rate cut, so what exactly could they hope to gain from a smaller cut a month later? On the other hand of they don't cut, the market will certainly fall out of bed. What's a Fed Governor to do?

Meanwhile the dollar has been looking more like the yen...down, down, down. The entire world is getting very nervous about the dollar and it won't take much more downside to ignite an all out dollar panic. The bond market has been rallying into this anticipated rate cut, but eventually the bond market is going to start discounting the inflationary impact of these rate cuts, which will cut the legs out from under the market and the economy.

As for today, I am betting that the Fed will not cut the fed funds rate. There is too little to gain from a small cut and big risk on the dollar front with a bigger cut. Holding firm will generate a sharp move down in the stock market, especially in financial stocks, but probably not a bear market. Holding firm will also stabilize the dollar and maybe even generate a dollar rally. Overall the Fed gains credibility by holding firm and buys time to try to work out the credit mess.

Update: Well, the Fed cut the rate by a quarter point. As expected the dollar and bonds dropped sharply. Stocks finished higher after an initial plunge and gold rallied to close just below $800. Notable: Bill Gross stated that another full point reduction will be needed to relax tightening credit conditions. The Fed may be contemplating just that, in increments. The bond market will not like that much. I don't think there is any way out of this that is not painful. Inflation here we come.

Alan Greenspan's "The Age of Turbulence"

Alan Greenspan has finally come forth to share his experiences with the Bush Administration and the Republican majority. This is a welcome blast of light shining on the super secret world of George Bush's Washington. Unfortunately it comes about six years too late. Tremendous damage has been done in those six years that might have been averted had he been willing to speak out while he was in office.

In his new book, "The Age of Turbulence: Adventures in a New World," to be released Monday, Greenspan "is harshly critical of President Bush, Vice-President Cheney and the Republican controlled Congress, as abandoning their party's principles on spending and deficits." For anyone who has been paying attention, these observations have been blatantly obvious from the beginning of the Bush regime. But coming from Greenspan, a man of enormous public esteem and a self described Libertarian Republican, they suddenly take on more gravitas and credibility, and will hopefully help to frame the utter corruption of the Republican Party and promote a clean sweep of the "evildoers" in '08.

New York Times front page review of "The Age of Turbulence" here.

More on Credit Hysteria

On Thursday morning, the Dow was down 8.2% from its highs on a closing basis with a Wednesday intra-day low of minus 10.7% (S&P down 9.1% and 12% respectively). In the face of this very normal correction the Fed dropped the discount rate 1/2% and signaled that it will do whatever it takes to calm the markets. Why?

If you want a blow by blow there is a torrent of commentary in all the media. You can read all the reasons why the economy is at risk and the sky is falling, reasons that have been extant for years by the way, that are suddenly urgent. There is a good article on Salon by Andrew Leonard that explains the basics in layman's terms. But let's go right to the bottom line first.

The bottom line is this is not the end; this is not the top. In the final analysis that's all you need to know. Of course we are playing probability games here, so there is always a chance that any given day is the end. But on this particular day the chances are very small. This does not mean that there are not issues, problems, perhaps even fatal problems with our financial system. It means that for the vast majority of us, unless we are directly involved with the mortgage industry, this is not the day that the piper is going to be paid. Why?

The most important indicator has to do with sentiment. Markets are products of human psychology. The fuel for the markets is fear and greed. Market tops are made with greed induced enthusiasm and bottoms are made with fear induced despair. The level of negative sentiment displayed over the past two weeks, rising beyond mere despair to the level of outright hysteria, is the sign of a market bottom, not a top.

However, the Fed move to drop the discount rate 1/2% with the economy humming along and the Dow down a mere 8% from its highs tells you something. It tells you that the Fed is very afraid of the credit bubble collapsing. This is a conversation for another day, but the practical implication is that the Fed will move aggressively to halt any downside momentum. I have learned from bitter experience that it does not pay to fight the Fed. It does pay, however, to follow in its wake.

Ignore Credit Hysteria

Negative sentiment regarding the sub-prime meltdown and subsequent normalization of credit spreads has reached the level of outright hysteria. Even people who should know better have suddenly morphed into Chicken Littles. I am one who is always ready to point out liabilities and weaknesses in the system, sometimes accused of being negative in fact, but this has gotten out of hand. The liabilities that bite you are the ones you aren't paying attention to. This one has already done its worst.

Credit spreads have been insanely narrow for a long time, distorting capital markets and enabling many marginal deals to be done. The normalization of credit spreads is a cleansing and strengthening event. It has already washed away many marginal players and it will force greater discipline on the marketplace, creating a healthier financial environment. The transition is, and will continue to be, painful for segments of the housing and mortgage markets, and for those who have grown accustomed to easy money from various "carry trades," but this is an overall positive development that will likely extend the life of the current expansion.

Update: The August 4th Economist goes into detail why "tighter credit conditions are just what the markets need."

The Blackstone IPO

Investors, market analysts, traders and all other interested parties should note June 22, 2007 on their calendars. This is the day the Blackstone IPO hit the market. (See TheStreet.com’s analysis of the deal.)

This is no ordinary IPO. Blackstone is one of the premier private equity companies and the Blackstone principals are masters of value -- they buy cheap and sell dear. They buy companies that are “under performing” for various reasons, "add value" by introducing operational efficiencies and technology, shutting down or selling unprofitable operations, outsourcing, off shoring, and offloading pension and health care obligations. These activities greatly increase the cash flow to the bottom line and to the shareholders, in this case the Blackstone principals and their investors. But that is not the end of the game. Increased profit and cash flow is very nice, but the big bucks are made when the transaction is completed.

Private equity companies complete the transaction and realize their profit by creating a "liquidity event." This is either the sale of a portfolio company to another company, or the sale of the portfolio company through an IPO -- at a multiple of earnings. In this case Blackstone chose to offer shares in itself rather than offering the individual portfolio companies or the funds they manage. The fact that Blackstone has seen fit to do an IPO signals that the principals believe they have maximized the value of their portfolio and want to start cashing in. They are selling dear, and would not be selling if they thought their stock was anything other than dear.

If the Blackstone principals believe that they have realized the bulk of the value from their portfolio, that would indicate that valuations in general are at a peak...and it also sends a signal to the dozens of other private equity companies which will now be looking for a liquidity event as well. In fact KKR, another legendary private equity group, has also announced its intention to offer an IPO. Others will surely follow. This new supply of stock will put pressure on the market, a turnabout from the steady disappearance of stock caused by the buying up and privatizing of public companies during the buyout boom of recent years.

The private equity boom has been fueled by cheap money. Blackstone and other private equity companies, and public corporations as well, have been able to finance their acquisitions by selling junk bonds at very low cost. That source of money is now starting to get more expensive as lenders have suddenly realized that they are taking more risk than they are getting paid for. This will also start a trend toward issuance of stock rather than debt as stock values are high and debt is now getting more expensive. So from various sources we will see an increased supply of stock coming to market.

General liquidity and cycles indicate that the top is not upon us quite yet, but it is clearly time to be more selective and more cautious in the stock market. Historically we will be able to look back upon the Blackstone IPO as a demarcation point and the beginning of the end of this bull market.