A Slowdown <I>Can</I> Be Good for the Market - TheStreet

At first it seems totally counterintuitive: How can a slowdown be any good for the stock market? Doesn't everyone know that earnings are what drive stocks? And don't earnings get hurt in a slowdown? Isn't that a crummy reason to buy stocks? Aren't we just betting against ourselves?

Before you think you are nuts or stupid or out of it, let me just tell you that I didn't buy this logic one bit when I got in the game. Slowdown? What the heck? A buying opportunity? What kind of fool do you take me to be?

But I was wrong. I want to walk you through the logic of this so you will see why I became more bullish as the slowdown became more pronounced, and how I will remain that way until the slowdown becomes too pronounced (only then would I be concerned about severe earnings shortfalls for many companies).

First, understand that much of what I say is based on history. In other words, I am not making this stuff up. I am not giving you some idle blather that is based on something I read in a textbook. This is important because some things, like high employment and low inflation, weren't supposed to happen in this country and they have. This is not theory.

There is nothing wrong with a strong economy. We can have good growth without inflation. But there are periods in which things get too heated, in which manufacturers and retailers and home builders can put through price increases easily. That's inflationary. We don't want that. We want steady prices. That is an imperative of the

Federal Reserve

.

If the Federal Reserve sees imbalances or pricing pressures in any portion of the economy, it will act to quell those imbalances. In particular, the Federal Reserve is dead set against prices that rise so fast that they cause speculators to take down credit to buy something that they think will rise quickly in value. The Fed is insensitive to whether that is farmland, apartment buildings, oil or stocks. If it becomes evident, obvious, and easy to borrow money to buy something today that you can sell tomorrow for a much higher price, the Fed knows that people will find that imbalance and exploit it.

If you don't believe in that, or think that's silly, I don't care. You may think taxes are silly. You may think that the

Securities and Exchange Commission

shouldn't enforce insider trading rules. Again, I don't care. They are enforced and they are the reality. Maybe another Fed might be blind to these imbalances or think they will cure themselves. Maybe you think they will cure themselves. Again, it doesn't matter. The Fed believes that's its job. That's all you need to know for this piece.

If the Fed sees imbalances, it can raise short-term rates to quell those imbalances. If it has to, it can take short-term rates to the point where it can cool off not only the imbalances but the whole economy. Again, you have to suspend the notion that the Fed is not that powerful. And you have to accept the notion that short rates matter. How do they matter? When people buy things, they often buy them on credit. Businesses buy things on short-term credit. If the price of that short-term credit goes up too much, it becomes prohibitive to stockpile inventory. If you can't stockpile inventory, whether it be cars or stocks, you can't exploit the imbalance to your own favor. It becomes too expensive.

Psychologically, also, people who run big money in this country are acutely aware of the power of the Fed. They are aware because they look at history. They know that when the Fed moves rates up dramatically, equities go down. So they know they have to sell stocks if the Fed gets too vigorous in fighting inflation, because when the Fed gets too vigorous, the economy stalls or drops hard. They know this because it has happened before. Every time.

"Ahh," you say, "hold it, how about if the holders of equities are all people who don't know this equation? They are all people who say that they don't care about the Fed. They are all holders who don't understand this process and are ignorant of history.

They are holders who don't know to sell.

"

To which I say, yes, certainly, there is a chance that one day we will have a set of equities that are totally and entirely owned by people who don't give a hoot about the Federal Reserve. But we are not in that world yet. Right now, the institutions own the majority of stocks and they know to sell. They will not be lured into thinking otherwise.

So, if the Federal Reserve wants to cool the economy, it can do so, and with that it can bring stocks down because the owners of stocks know they can fight the Fed a little bit, maybe even for a couple of rate increases,

but they can't go 10 rounds with the Fed and expect to win

.

Lately, a consensus had built that the economy was so strong that the Fed had a lot more work to do to stem this inflationary spell. Once the consensus swings to a belief that we need more than 100 basis points, or more than two 50 basis-point tightenings, most money managers would rather sit things out. They would rather sell now than take the punishment of a couple of more big rate increases.

So, if you get data that jar the consensus, that make money managers feel that maybe we don't need more than 100 basis points' worth of tightening, that maybe, just maybe, we are done, or that there is only one more Fed increase for insurance purposes only, then you will get a buying stampede. You will get people who feel that the worst is over.

That's why I kept harping on that

1994 analogy because, at the time, we finally, at one beautiful moment, realized that the Fed was done and we caught the greatest buying opportunity of the last several years. We may be at that same juncture now. I caught it then. I am not going to miss it this time. It was a great buying opportunity because unlike the last few selloffs, things besides tech could be bought. Many sectors could be bought. Much stuff worked. A bull market resumed. Many issues rallied.

Despite what you think about the last 3000 Nasdaq points on the way to Nasdaq 5000, there were thousands of stocks that remained in a bear market, particularly those on the

New York Stock Exchange

. We catch a real bull move and that won't be the case. The breadth will be great.

Now, back to the original question. Won't all of these tightenings hurt the economy and make for earnings shortfalls that will bring down stocks? Yes, certainly, those companies that need rabid consumer spending to make their earnings estimates will be hurt. They will have shortfalls. I don't know if you've noticed, but stocks such as the chemicals, papers, aluminums and autos -- companies that need some serious spending and

GDP

growth -- have been going down severely in the recent months and they are not rallying now for that same reason.

But there are a lot of other stocks that have come down because people expected that if the Fed kept raising rates aggressively, they would be hurt severely. However, if the Fed stopped raising, if the Fed broke the consensus, they would be cheap. These stocks include the banks, brokers, savings and loans and insurers. These stocks are priced for 100 basis points or more. If we don't get them, they could go higher. (Again, in 1994, coming off the tightenings, these stocks simply exploded upward in a great and bountiful move.)

In the meantime, whole groups of stocks that have consistent earnings, whether rates go up or down, draw no attention because they won't disappoint. Remember, Joe Blow portfolio manager wants earnings growth wherever he can find it. If he can find 40% year-over-year growth in oil and aluminum stocks, he will sell stocks that generate 12% to 15% growth for them.

But if the 40% growers falter, he will make a beeline for consistent growth, hence the action in the foods, drugs, tobaccos and beverages. That's why I have to turn more bullish when I see softer data. Softer data set up the whole chain of positives that leads to higher prices -- counterintuitive though that may appear.

I know this stuff is difficult. I know that there will be people who still will say that the imbalances haven't been cured yet. Some of you are saying that you think the speculators will come right back. What I think you may be missing is the vaporization factor. Money that is crushed, money that is borrowed against and then taken away when the collateral loses value, is money that has vanished and can't be borrowed against again even if you want to borrow against it. It doesn't exist.

Hence, the bullish nature of the decline in margin debt. The speculators still may want to speculate, but you have to ask yourself, after the declines from March till June, with what? What will they speculate with if their money has been destroyed?

Yes, we can wait until we see even more data. We can wait to see if the data don't get strong again. I know I wanted to see a couple of months of weaker data before I pulled the trigger, but these data were so weak and convincing, and your anecdotal data nationwide so powerful (meaning the anecdotes you send me via email) that I can't wait. Which is why I promised to give you the heads-up when things were slowing. It would be great to say, "It's all clear, everyone back in the pool." But everyone already will be in the pool by then and there won't be any room. Which is why we took action yesterday to get longer, and why we will put more money to work today.

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund had no positions in any stocks mentioned. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

jjcletters@thestreet.com.