Agora Financial’s Rude Awakening

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Laguna Beach, California

• Massive write offs for the banks…and the market soars,
• New records, old tricks: a look back at rate cuts of yore,
• What’s different this time? Is oil jilting the buck too? 5 golden
  opportunities and plenty more…

Eric Fry, reporting from Laguna Beach, California…

Heads, the bulls win; tails the bears lose.

No matter which way the penny lands these days, the U.S. stock market soars. More to the point, no matter how low the dollar falls, the U.S. stock market soars…as do the stock markets of the rest of the world.

Or maybe the U.S. stock market is soaring BECAUSE the dollar is tumbling. A weaker dollar, after all, boosts the profits of dollar-based multinationals like General Electric and MMM.

Despite the buoyant conditions on Wall Street, however, the stench of dire economic news continues to waft along Main Street. As our good friend, Chris Mayer, editor of Capital and Crisis, observes:

“This week’s big news items were the horrific losses of two big financial institutions. UBS reports that it will write down as much as $3.4 billion worth of assets as a result of U.S. mortgage woes. As a result, UBS will report a loss in the third quarter. This follows markdowns by Goldman Sachs, Lehman, Bear Stearns and Morgan Stanley.

“Meanwhile, Citibank reports that it will post a 60% decline in profits due to a write-down of $3 billion in mortgage securities. The meltdown in July and August this year marked a key turning point in the mortgage -bubble fiasco. I’d expect that the financial companies will all report weak earnings this quarter, and probably next, as well.

“The thing is,” Chris continues, “there will probably be more problems in the mortgage market for another year or so. During the boom, a lot of people took out adjustable-rate mortgages. The bulk of those will reset in the fourth quarter of 2008 and the first quarter of 2009. That could spell big trouble if rates are higher. It could mean more defaults. It could imperil financial institutions. At a minimum, it’ll take a bite out of consumers’ discretionary income and drag down the earnings of companies trading in mortgages.

“My guess is that the housing market doesn’t get any better until after those dates pass. I think we can be patient. No point in trying to pick bottoms with homebuilders and mortgage lenders. If history is any guide, and it usually is a pretty good one, then we’ll have plenty of time to catch the fat part of the next up move when it comes.”

Sage advice, it would seem, but….

Very few sock market investors wish to be bothered with scary stories about bankrupt mortgage lenders, or multi-billion dollar charge-offs, or the idea that the weakening dollar might continue weakening. All news is good news, they tell themselves, because “the worst is over.”

We wish we could embrace these feel-good delusions. But we fear success, Bernanke style. The Fed Chairman has signaled his determination to combat a credit crisis with credit creation, which should be bad for the dollar, but good for gold. The credit-induced economic revival he seeks can only arrive on a Superhighway of newly minted dollars. That’s why every forward-looking investor should pay attention to the fragile state of our beloved greenback.

“As you know,” Chris Mayer continues, “the dollar has been hitting all-time lows (as measured against a basket of foreign currencies) with relative frequency. Remarkably, there are many reasons why it should continue to go lower.

“There are a lot of dollars in the world, “he says. “I picked up this interesting nugget from the latest issue of Grant’s Interest Rate Observer: ‘As much as 60% of the U.S. currency circulates outside this country, according to the U.S. Treasury, meaning $488 billion out of $813 billion.’ That figure doesn’t speak for the trillions of electronic dollars that have left these shores and now reside in banks in China, Japan, Russia, Saudi Arabia and many other countries.

“The thinking goes,” Chris reasons, “that these dollar-buyers may slow the pace of their buying one day. Or perhaps they will decide to lighten up on greenbacks. In either case, that means the dollar exchange rate will trend lower yet.

“To protect against a falling dollar,” Chris concludes, “it is best to own things that ought to hold their value against it. These things tend to be tangible assets for which there is a global market. Commodities (including the precious metals) would be one. It is no coincidence that oil and gold are making new highs as the dollar tumbles. Another may be assets in a country where that currency ought to appreciate against the dollar. Then the dollar-based investor gains a currency windfall when converting gains back to dollars.”

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Fight the Fed…Sometimes
By Ed Bugos

If the characteristic mark of a selling panic is that everyone is on the same side of the market, and they are selling everything — the good, the bad, and the ugly — the action immediately following the Fed’s surprise rate cut two weeks ago could be described as a buying panic. Everything went up. Most everything is still going up, except for currency, bond and home prices, disregarding the occasional backfilling on the way to higher ground.

Bernanke’s surprising interest rate cuts deserve much of the credit – or the blame – for the stock market’s dazzling performance. The S&P 500 just posted its biggest quarterly gain since 1998. But rate cuts don’t always produce a lasting magical effect. In fact, they sometimes produce no magic whatsoever. A look back at previous rate-cut cycles may shed some light on what we should expect this time around.

In the next 1,047 words, I’ll show you what happened to the stock market after past rate cuts. To give away a partial conclusion, stocks tend to rise. There are important reasons why that may not happen this time. But first, let’s take a look at what the Fed did on September 18th.

The Bernanke Fed used the element of surprise to its advantage. It lowered its target rate 50 basis points (0.50%). The Fed also cut the rate it charges banks on loans directly by 50 basis points (0.50%). The markets expected half that.

In its prepared statement, the Fed said it was worried about the effects of tightening credit conditions on the economy, and that its rate cut was “intended to help forestall some of the adverse effects on the broader economy…and to promote moderate growth.”

Incidentally, the Fed also expressed concerns about inflation. But talk is cheap. If the Fed were genuinely worried about inflation, it would not have slashed interest rates when the risk of rising inflation is so obvious. The Fed would not have slashed rates when commodities like gold, oil and wheat are threatening to make RECORD highs and the U.S. dollar is slumping toward historic lows.

On the other hand, Bernanke probably realized that an “expected” rate cut would have caused stock prices to head straight down. In other words, he was “targeting” asset prices, primarily to try to rescue America’s major lending institutions from the consequences of their reckless lending and speculating.

The stock market responded as hoped to Bernanke’s surprising rate cuts, while both the dollar and gold responded as feared. Even after yesterday’s selloff, the gold price has jumped more than 10% since the Fed started cutting interest rates in mid-August. And why not? Bernanke’s dramatic rate cuts have been the best buy signal for gold since the news of his appointment as Federal Reserve Chairman.

Meanwhile, the dollar has dropped to new all-time lows. Unfortunately for the Fed, therefore, the message of the tape is that the market is worried about inflation. And inflation is not usually a friend of the stock market.

Former Fed Chairman, Alan Greenspan, compares the recent crisis in the financial markets to the crises of 1987 and 1998. As it happens, both of these financial crises prompted a one-off rate reduction, which apparently pre-empted a recession. And the stocks markets recovered promptly. There were no follow-up rate cuts. Perfect! So, the thinking goes, this is gonna be just like those other times. The rate cut is just one helluva insurance policy. It’ll pre-empt recession and it’ll boost share prices.

I look at it differently. This is not 1987 or 1998. Indications suggest that today’s crisis is bigger and more widespread than either 1987 or 1998. We know it reaches beyond U.S. borders. Moreover, the bull market in the years leading up to 1987 and 1998 was on sounder footing — both periods saw a relatively benign price and economic environment in the U.S….commodity and other prices weren’t soaring like they are today.

Yet another important difference between today and both 1987 and 1998 is that the Fed did not react until the stock markets were off some 20-30% in these latter periods. Today, the market was only 11% off its all-time high, at worst! Aside from those two instances (and 1995), there has been no other year since 1950 when the Fed cut rates by less than 1% without follow-up rate cuts.

It did cut rates in 11 other instances, but those were actual campaigns, lasting anywhere from nine to 40 months, averaging about 600 basis points (6%) in rate cuts – and nothing less than 200 basis points.

In nine of those 11 instances, a recession occurred anyway.The average return on the Dow in the 12 months following the start of all 14 Fed rate-cutting campaigns since 1950, excluding dividends, was about 16%. Excluding the one-off campaigns of 1987, 1995, and 1998, which saw the Dow gain an average 26% in the 12 months following the first rate cut, the average return (excluding dividends) on the Dow falls to 14%. If we further reduce the sample to those instances in which the Fed began cutting rates before the Dow fell more than 10% (1960, 1980, 1981, 1989, 1995, and 2001), as today, the expected return falls to 9%. We would also point out the S&P 500 has ALREADY gained 9.6% since the Fed began cutting interest rates on August 17th!

Excluding 1995, this expected return falls to just 7%, which is a far cry from the 22%average returned in instances when the Fed waited until the stock market was down over 20%. Moreover, in two of the instances above (1981 and 2001) in which the Fed started cutting rates before a significant correction in stock prices, the returns were actually negative in the 12 months subsequent.

History suggests that rate cuts tend to work out better for stocks when they start after a major stock price correction (more than 15%) when the inflation and price environment is relatively benign and there is no profit or economic slump. In the current situation, the Fed is missing at least two of these conditions. An even greater risk for the Fed is that if the stock market doesn’t sustain a rally, confidence in its future policies will falter.

Since the stock market has already gained more than 9% since Bernanke’s rate cuts began, the stock market’s risk-reward profile has shifted toward risk…while gold’s has shifted toward reward.

Buying gold and other hard assets is probably not the worst way to protect yourself against the excesses of “New Era” central bankers like Ben Bernanke, or against the goof ups of bureaucratic policymakers in general.

The dollar’s fundamental underpinnings have become so feeble and suspect that gold is not simply likely to advance in price like everything else; it is likely to rise faster and farther than almost any other asset.

The investment follow-through in coming weeks will be telling. But after some normal profit-taking from the $740 level, along with a possible re-test of the $700 floor, I’m looking for gold to break to new record highs above $900, and maybe even through $1,000.

And when it does, just say, “Thanks Ben!”

[Joel's Note: Here’s a report on the best 5 ways to play Bernanke’s gold bull. Read it for all the reasons you wouldn’t buy his dollars.

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Rude Endnote: Even before Bernanke’s rate slash the dollar was ailing against almost all major currencies. Now, as it falls almost as fast as the delusional stock market soars, confidence has all but evaporated. It’s like the sick shrimp that none of the seagulls want to eat.

Yesterday we mentioned briefly that currency speculators here in the Gulf Cooperation Council have been predicting a revaluation of local, dollar-pegged currencies. Frenzied traders bid up the UAE dirham and the Saudi riyal to near record highs as a result. Saudi British Bank did their best to calm the waters by saying, ahem, they would only dump the buck, “if the dollar weakens at an alarming rate.”

Now, eager not to miss any of the action, it’s OPECs turn to muddy the waters.

International banks and analysts have hinted at the possibility of the Organization of the Petroleum Exporting Countries changing the price of oil to a currency basket, rather than the dollar. 

“If the dollar were to lose its lustre as a reserve currency this could prove disruptive to the global financial system.” Reads a note released by Merrill Lynch yesterday. “In the Middle East the market has become concerned that more countries would drop the dollar peg with Opec potentially changing the oil price to a currency basket rather than the dollar.”

Could we soon see the world’s primary energy supply dump the world’s reserve currency? That would be one big jilt at the altar. We’ll keep you posted.

Cheers,

Joel Bowman
Rude Awakening