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.

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.