They Let the Fed Out and the Market Acts Like a Lost Dog

SAN FRANCISCO -- They sold the news that the Federal Reserve lowered the fed funds and discount rates by 50 basis points today. Then they bought the news. Then they sold it again, leaving the Dow Jones Industrial Average up a scant 0.1%, while the S&P 500 fell 0.6% and the Nasdaq Composite shed 2.3%.

The Fed's statement, particularly its comment about the need for "rapid and forceful response of monetary policy" to recessionary pressures, suggests a distinct possibility of additional rate cuts, and soon. Fed funds futures are currently pricing in a significant probability of a rate cut prior to the Fed's next scheduled meeting, and a near-certainty the central bank will ease again March 20.

The debate about whether the Fed eased too much or not enough continues, although today's weak fourth-quarter GDP and Chicago Purchasing Managers Index report provided more fodder for the latter. But if the Fed is taking its cues from the market and not vice versa, as I argued last night, then the central bank held to form today by fulfilling the market's expectations.

From the Top

Speaking of last night, the column generated lots of feedback (thanks) and a couple of points worth pursuing/clarifying.

First, many readers declared as folly the argument that Fed rate cuts now might create a moral hazard, because the Fed is now trying to "undo the mistakes" made in 1999-2000 when it "tightened too much" and brought pain to the investing masses. But what necessitated the Fed's tightening in 1999 and early 2000? According to critics, its overly aggressive and moral hazard-inducing rate cuts in 1998 to "bail out" Long Term Capital Management and its lenders, which included nearly every major Wall Street firm. (For more on that, I urge you to read Roger Lowenstein's When Genius Failed: The Rise and Fall of Long Term Capital Management.)

Some of the harshest Fed critics go back to the central bank's role in the resolution of the peso crisis in 1994-95, but let's agree to start the moral hazard clock in 1998. The three rate cuts in the fall that year, followed by the Fed's aggressive stance regarding liquidity in the pre-Y2K months, created one of the biggest asset-inflation bubbles in history, according to the moral hazardists. An avalanche of "easy money" spurred investments in companies with specious business plans. More-established companies weren't immune either, expanding rapidly via investments in "plant and equipment," as well as people.

With the myriad layoff announcements and curtailment in IT spending -- the latest evidence being the 4.7% fall in nonresidential business investment in equipment and software in the fourth-quarter GDP report -- we are now seeing the flip side of that. Or so the argument goes.

But if you believe the Fed "overshot" with easing in 1998, and then tightened too much in 1999-2000, how can you have faith it's going to get it "just right" this cycle?

Skeptics worry that a slow erosion of that faith will undermine the Fed's ability to bolster investor confidence.

I certainly "own" (as they say here in Northern California) the criticism that recent articles have been extremely curmudgeonly. By examining the potential risk in the unabashed optimism of the gurus (among others), I risked focusing too heavily on the less-pleasant alternatives.

Although it's hard to believe "everybody" is skeptical when respected pundits such as UBS Warburg's Ed Kerschner publish reports titled "Winning is Easy When the Fed is on Your Side," I acknowledge the phrase "Don't fight the Fed" didn't become a clich because it's got a good beat.

Even Fed critics agree it's imminently danceable.

"I'm totally open to the idea that [the] Fed ease and tax cuts won't work to revive the economy, but you can't start off on day one assuming that, because it's always worked in the past," Jim Bianco of Bianco Research in Barrington, Ill., said earlier this week. "We are not Japan. Maybe it turns out that first 'it has to work' call will turn out wrong. But 'you can't fight the Fed' [stands] until you give me some real evidence it's not working."

Dr. Lee Thomas, managing director at Pimco, a Newport Beach, Calif., fund-management company with more than $200 billion in (mainly fixed-income) assets, agrees that this rate-cutting environment is an investing opportunity. But, as he wrote recently, Fed rate cuts in 1998 "produced a stock market bubble," which led to "overconsumption" and "excessive investment in capital goods."

The economy "has not yet bottomed" because many companies still need to write down those investments, he concluded.

But Thomas challenged predictions the U.S. is facing a multiyear recession, or Japan-style deflation. Unlike the Bank of Japan, "the Fed ... has responded quickly to the U.S. economy's weakness, and will continue to loosen aggressively to turn the economy around," Thomas wrote. "Perhaps we will some day have to pay for reflating the economy. But practically speaking, Mr. Greenspan will do everything he can to defer that day of reckoning to the future."

P.S.

Faithful readers may recall that when we last updated views of The Elliott Wave Financial Forecast, the newsletter had predicted the next Fibonacci turn date would come at the end of January. Again, the turns are designed to identify when short-term changes will occur, not which direction the market will go, the theory being whichever direction the market is going heading into the turn date, it will reverse course thereafter.

The market has been "rallying strongly into the window," co-editor Steve Hochberg said today. Thus, "this [turn] will mark a high" for the major averages.

We'll have to see how that prediction unfolds, but note the "fade" call dovetails with the most recent predictions of Don Hays of Hays Advisory Group.

Dang, and just when I was learning to stop worrying and love the market.