Stocks Hesitate Pre-Fed

Yahoo!'s warning and weaker housing starts inject anxiety. Plus, liquidity abounds.
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Fears about the economy resurfaced Tuesday as the markets responded primarily to another wave of negative housing data. A coup in Thailand and an earnings warning from

Yahoo!

(YHOO)

shook traders as well, as angst trickled into the stock market midday. But the major averages staged a strong reversal in the last hour of trading.

After dropping as low as 11,480.56 intraday, the

Dow Jones Industrial Average

finished down 0.12% to 11,540.91. The

S&P 500

fell 0.22% to close at 1318.31 vs. its intraday low of 1312.17, while the

Nasdaq Composite

fell 0.60% to close at 2222.37 after declining to 2202.93 intraday.

In economic news, the Census Bureau reported a weaker-than-expected 1.65 million housing starts in August -- a 6% decline, and the third monthly decline, marking a 19.8% year-over-year drop. August showed the steepest year-to-year drop since March 1995. Economists had expected 1.75 million new homes started in August.

Even a benign inflation data point and another decline in oil prices couldn't keep investors very upbeat. The Labor Department reported that the producer price index rose 0.1% in August while core PPI fell 0.4%. This puts year-over-year PPI at 3.7% with core PPI at 0.9%.

As the

Federal Reserve

came to the end of its rate-hike campaign, it forecast that a slowing economy would dampen inflation. With that, the market turned to the slowdown as opposed to the inflation threat, hoping the economy will slow enough, but not too much. With the Fed now on pause, the market suddenly sees bad economic news as "bad news." Perhaps that is why Yahoo! tumbled 11.2% after warning of a dropoff in advertising sales.

In addition to Yahoo!, the Comp's seven-day winning streak was snapped thanks to weakness in

ImClone

(IMCL)

, which fell 4.5% after a federal court ruled against it in a case involving a patent on its Erbitux cancer drug. (In after-hours trading, however,

Oracle

(ORCL) - Get Report

was recently up more than 11% after reporting

better-than-expected first-quarter results.)

The Fed is expected to stand pat at the conclusion of the FOMC meeting Wednesday, but the markets have taken the next step, pricing in odds of a rate cut in the not-so-distant future.

While inflation and inflation expectations are diminishing, and the economic slowdown is clearly here, there still is little evidence the Fed's two-year tightening campaign did much to stem the huge tide of liquidity in effect since 2002.

Small-risk premiums on high-yield and emerging market debt, low volatility in the market, high investment-grade corporate bond issuance, and the sloshing pools of private equity money ready to go to work --

Freescale Semiconductor

being the most recent beneficiary -- are just some of the evidence of still-plentiful liquidity, says Scott Frew, general partner at Rockingham Capital Partners.

Technically, the monetary base may have shrunk due to the Fed's 17 rate hikes. But money is readily available to anyone or any business that needs some. In the corporate credit markets, where risk premiums are low, access to capital remains robust.

The proliferation of the leveraged loan market and the speedy advance of credit derivative markets -- where investors can buy protection against defaults -- has kept bankruptcies to a minimum and lending less risky. Despite the Fed's tightening, investors can virtually lend with immunity, and borrowers can obtain cash with impunity.

"There has been some diminishment of excess liquidity," says Michael Darda, chief economist at MKM Partners. But the effects of excessively accommodative monetary policy after the Internet bubble burst have not filtered out of the system completely.

To wit, the number of newly rated bank credit facilities of U.S. speculative-grade (read: high-yield) companies grew by 86% year over year in the two months ended Aug. 31, according to Moody's Investors Service. These facilities grew by 56% through the first eight months of 2006.

Also, Moody's speculative-grade default rate fell to 1.6% in August from 1.7% in July. Moody's noted the default rate has remained in a narrow range over the past 16 months, never topping 2.1% or falling below 1.6%.

Such loose lending standards are hardly the picture of tight liquidity.

"Credit creation away from the traditional banking system is running rampant," Richard Bernstein, chief investment strategist at Merrill Lynch, wrote in July after the Fed delivered its 17th rate hike. Bernstein argues that the given the development of such risk-management techniques and derivatives markets, the lags associated with monetary policy may be longer than usual, and the Fed may have to tighten more than expected. "It should be no surprise that the Fed has not yet severely impacted the U.S. economy," he writes.

While August has revealed some evidence the Fed's rate hikes have had an impact on the economy, their effect could not be called severe by any stretch.

So, with the fed funds futures market raising the odds Tuesday of a rate cut in the first quarter of 2007 to 25% from 2%, it is not necessarily hard to imagine what adding liquidity to this picture might mean.

Falling commodities prices and the stabilizing dollar show that things are moving in the right direction. But a rate cut could just "bring back the inflation threat, and reinitiate an upturn in inflation expectations all over again, meaning the Fed would have more work to do," says Darda.

Indeed, the Fed's "close call" to keep rates steady at 5.25% in August is a reminder that the central bank is likely to retain its so-called tightening bias, while acknowledging the inflation threat has moderated. Of course the market will have to wait for the FOMC minutes, but Richmond Fed President Jeffrey Lacker's dissent last month remains a thorn in the Fed's side. Next month, notoriously hawkish St. Louis Fed President William Poole becomes a voting member of the FOMC, which could introduce even more dissent, formal or informal, says James Bianco of Bianco Research.

For now, Goldilocks was revealed as merely a Princess Leah-like hologram -- maybe she's real, but she's untouchable, or at least in a galaxy far, far away.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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