Agora Financial’s Rude Awakening

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Baltimore, Maryland

• What the rate cut really spells for your investments,
• High flying stocks and plummeting dollars,
• Pulling strings on Cramer’s decibel level and more…

Eric Fry, reporting from Baltimore, Maryland…

“Market bubbles don’t really pop,” observes Paul Tustain, director of BullionVault. “They hiss a bit, reflate a bit, and then hiss a bit more. This tendency gives forward-looking investors the chance to act, and usually on favorable terms.”

Yesterday, the U.S. stock market provided some extremely favorable terms to any investor who wished to lighten up on equities. The Dow Jones Industrial Average closed at 13,913, less than 1% below its all-time high. This near-record close follows hard on the heels of a major credit crisis that seemed to imperil the entire U.S. banking system.

All summer long, lending institutions went belly-up, hedge funds blew up, mortgage backed assets imploded under the weight of excess leverage and erroneous assumptions, and Jim Cramer screamed for a Fed bailout.

Cramer finally got his wish. Federal Reserve Chairman, Ben Bernanke, slashed interest rates and the stock market rocketed heavenward. Another crisis averted…or so most investors seem to believe.

In fact, a credit crisis still persists in nearly every corner of the U.S. financial system. But almost no one doubts that the crisis has ended…or that it soon will. Almost no one doubts that Ben Bernanke’s recent interest rate cuts will restore the mighty American financial system to peak form.

“Credit turmoil is still simmering beneath the surface,” warns Mish Shedlock, co-editor of the Survival Report, “even if one does not see it in the equity markets right now. Bloomberg is reporting, ‘Commercial Paper Market in U.S. Shrinks for Seventh Week in Row, Fed Says:

‘The U.S. commercial paper market shrank for the seventh straight week as the Federal Reserve’s interest rate cut fails to improve conditions for short-term credit.

‘Debt maturing in 270 days or less continued its biggest slump in seven years, falling $13.6 billion in the week ended yesterday to a seasonally adjusted $1.855 trillion, including a $17.3 billion decline in asset-backed commercial paper, according to the Federal Reserve in Washington. The week’s decline is smaller than the previous week’s drop of $48.1 billion, a sign that buyers are starting to return to the market after the Fed’s half-point reduction Sept. 18 in its benchmark interest rate.”

“Notice the absurdly positive spin in this statement: ‘The week’s decline is smaller than the previous week’s drop of $48.1 billion, a sign that buyers are starting to return to the market.’ Since when does a decline mean that buyers are returning?

“Furthermore,” Shedlock notes, “the Fed executed a whopping $38 billion in repos (short term bank loans) today, agreeing to take $22 billion in mortgages as collateral. Traditionally, the Fed accepts only Treasuries as collateral. This is a sign of continued panic by the Fed to contain these mortgage-related problems.”

In other words, the current conditions in the credit markets bear a much closer resemblance to crisis than to normalcy. But the stock market’s resurgence casts a rose-colored hue upon all things financial. How bad could things be if the stock market is close to a record high?

Quite bad indeed, if you happen to calculate your net worth in U.S. dollars. The greenback has dropping as sharply as the stock market has been rallying.

Blame Bernanke.

Sooner or later – probably sooner – the dollar-holders of the world will realize that Bernanke will sacrifice the dollar to “save” the economy. They will realize that he will sacrifice dollar-lenders in order to save dollar-debtors. But no one likes being a patsy. The abused dollar-holders of the world will not suffer abuse indefinitely. Instead, they will seek the comfort and sanctuary of non-dollar alternatives like euros or Swiss francs or gold or bushels of wheat.

“This is rational behavior,” says BullionVault’s Tustain, “and it is beyond the power of central bankers to control.”

In fact, central bankers don’t control much of anything in the modern world, other than a few Wall Street Journal headlines and the decibel-level of Jim Cramer’s rants. Bernanke’s recent rate cuts produced a financial adrenaline-rush. Stock prices are higher, but the crisis remains…which means that stock prices might soon be lower again…as Chris Mayer explains in the column below.

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Bernanke to the Rescue…Watch out!
By Chris Mayer

As the market began to buckle at the knees in late July, ertain CNBC commentators and other observers of the financial world began to howl like whipped dogs for a rate cut. Specifically, they wanted the Federal Reserve to cut the federal funds rate target, a key interest rate from which many other interest rates take their cue.

The thinking goes that a rate cut would help the stock market and everyone would make money again. Crisis averted. Finger in the dike and all of that. But as financial analyst Michael Belkin recently noted, “The consensus is 100% convinced that the Fed rate cuts are always bullish (don’t fight the Fed, blah, blah, blah). But the data say otherwise.”

Ah, the data. Yes, there is the little matter of looking to see what actually happened the last time the Fed began cutting rates. This involves some minimal work. Most of the blowhards on TV would rather stick needles in their eyes or swallow live goldfish. But if you just look at the last set of rate cuts, you dig out a rather stunning picture.

Specifically, during the last rate cut cycle, the S&P 500 - a common stock market benchmark - fell 47%. From a starting point of 6.5% in January 2001, the Fed cut rates all the way down to 1%. Yet it didn’t seem to help the stock market.

For another example, look at Japan. The Bank of Japan cut rates practically to zero by 1995, yet the Nikkei would still get cut in half after that. Bringing these things up to a central banker is like talking to one of Napoleon’s marshals about the Russian campaign.

What does this mean? It means something painfully obvious: Interest rates aren’t the whole shebang. Other things matter more, such as the price you pay for the stocks you own…And which stocks you own.

Back in 2001, we had the dot-com bubble finally popping. The whole technology, media and telecommunication mania finally ended. According to “Bull: A History of the Boom,” by Maggie Mahar, “By February 2002, 100 million individual investors had lost $5 trillion, or 30% of the wealth they had accumulated in the stock market - just since the spring of 2000.”

As a result of this massive unwinding - which included several big bankruptcies, job losses, etc. - we had a recession. There is debate about when it exactly started and when it exactly ended. Point is this: The economy did some shrinking during this period.

Today, we have a major crack in the mortgage markets. Bad bets on mortgage-backed securities have completely wiped out some hedge funds and dealt heavy losses on investors across the spectrum. The mess cleaved deep wounds in the balance sheets of many mortgage lenders, crushing their stock prices and threatening their very existence. The biggest mortgage lender in the U.S., Countrywide, faces possible bankruptcy.

Housing prices are falling. The 3.2% drop in the second quarter was the steepest rate of decline since Standard & Poor’s began tracking its nationwide housing index in 1987. Inventories are building, too. The U.S. supply of unsold homes recently hit a 16-year high.

So as with the 2001-2003 period, you have a large bubble finally bursting. Hard to imagine that the mega-bust in housing doesn’t at least slow down economic growth or toss us into the winter marsh of a recession. In which case, rate cuts will be like white lace on a coal miner - which is to say, utterly irrelevant, and even a little ridiculous. Short term, interest rate cuts produce a few fleeting stock market rallies, but that’s about it.

I’m not predicting stock prices will fall as dramatically as they did in 2001-2003. Valuations are lower today, generally speaking. And every stock market episode is different. But I do think that you should ignore the Fed. What you own - and the price you pay to own it - will be much more important than anything the Fed does.

After all, some well-placed bets on commodity and housing stocks back in 2000 paid off handsomely only five years later. So there will be flowers in the coal pit for us to pick up today. I’m betting water, energy and infrastructure companies will be among them.

[Joel's Note: As a matter of fact, Chris recently told his readers to sell Lindsay Corp., one of the water stocks he recommended a year back, for a 100% gain. While the rest of Cramer’s friends flounder in the wake of the Fed’s rate cut, you would do well to sure up your portfolio with a few of Mr. Mayer’s choice investment picks. Click Here For All The Information You Need to Start Today.

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Rude Endnote: Wow…the Rude pens have been working overtime since we brought you James Howard Kunstler’s two parter on America’s New Religion. Emails of praise and complaint have been flooding our virtual mailbox over the past few days. Like this one from Farmer Jay in California:

“We grow, pack and ship fresh market oranges in California’s Central Valley. Our costs, like those of all manufacturing businesses, have been skyrocketing. Due to the nature of our fruit crops, our largest input cost is labor. With the increased focus on regulations and illegal immigration, labor is rapidly becoming even more expensive.

“In 1980 laborers made about $8/hr (before taxes), in 2007 it’s $13/hr with spikes to $18 or more when timing is critical and more laborers are needed. As these costs rise, I think Mr. Kunstler will be shown to be right in this area and we will be hiring more “gringos” for agricultural labor. With the way housing is going, they should be able to get a good deal on a place to live.” 

If you care to read what all the fuss is over and perhaps leave a comment of your own, be sure to check out our new look Rude site. Simply go to Agorafinancial.com and click on the Rude Awakening icon. You’ll find our partners, The 5-Minute Forecast, a host of interesting daily commentary from the whole Agora team, charts, books and plenty of other useful resources there. Check it out when you get a few minutes spare.

Cheers,

Joel Bowman
Rude Awakening