Words from the wise for the week that was (Sept 17 – 23, 2007)

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This is a rather quickly-compiled version of this regular weekly posting, but it nevertheless includes a few super quotes, as I have been spending most of the past two days on airplanes crisscrossing Europe. And this is also the reason for having been rather quiet with new content on the blog. But I am now finally making my way back to Cape Town on a 12-hour flight, affording me a few hours to put some words together (and sample quite a bit of South African red wine!).

Although physically exhausted after visiting five cities in as many days, I feel mentally refreshed to deal with whatever the markets may toss our way. Jogging alongside the Ljubljanica and Vltava rivers, surrounded by some of the most beautiful architecture on the globe in respectively Ljubljana and Prague, does tend to be extremely conducive for fresh thinking.

But back to business. Before highlighting some memorable quotes from market wizards, let’s briefly review the week’s market action on the basis of a few performance charts.

Markets, in general, were dominated during the past week by the Fed’s decision on Tuesday to reduce the fed funds rate by 50 basis points from 5.25% to 4.75%, signalling the first cut in four years. This was done to prevent a recession from taking hold and to address liquidity and credit-market problems.

Bernanke’s opening of the floodgate of liquidity calmed stock markets and triggered a rally across the globe as evidenced by the solid rise of 3% in the Dow Jones World Index. Emerging markets led the pack, with Hong Kong, India and China all recording new highs. But mature markets were no slouches either as seen from the Dow Jones Industrial Index putting in its best weekly performance for six months (including its best daily performance since March 2003 on Tuesday).

GLOBAL STOCK MARKETS

Source: StockCharts.com

US bond yields were again higher across the yield curve during the past five trading days as fears of higher inflation, on the back of the Fed’s easy-money policy and a soaring oil price, mounted. The rate of the US 3-month Treasury Bill, however, declined sharply as liquidity fears receded.

On the currency front the US dollar got slaughtered in anticipation of further interest rate cuts and recorded a 15-year low against a basket of currencies (using the US Dollar Index as a measure). The Canadian dollar, or so-called loonie (not shown on the graph), reached parity with the US dollar for the first time since 1976.

FIXED-INTEREST AND CURRENCY MARKETS

Source: StockCharts.com

Commodities were yet again characterized by strong increases across the board, helped in a big way by the plunging dollar, but also by a combination of supply constraints and strong demand from China and other developing countries. Interestingly, the Baltic Dry Index, a measure of shipping costs for dry bulk commodities, also surged to an all-time high during the past week.

Elsewhere in the commodities sphere crude oil was on a tear, recording a series of new highs. Gold bullion’s safe-haven and inflation-hedge status propelled the price higher, with its high-beta cousin, silver, faring even better.

Strong demand from China, as well as weather issues, boosted the prices of agricultural commodities to another weekly increase.

COMMODITIES

Source: StockCharts.com

Now for some words of wisdom from a couple of old hands to help make sense of the intriguing financial markets:

Marc Faber: Fed has no option
“My view is that unless the Fed is prepared to accept a vicious recession it has no other option but to bail out the system no matter how unpleasant the consequences will be in the future. The problem is really that in recent years the Fed has never controlled credit growth and that the monster needs now to be fed with even more money and credit growth.”

Source: Marc Faber, AME Info, September 10, 2007.

David Fuller: Comments prior to Fed’s rate cut
“My main concern is that they (central banks) risk falling behind the curve of events which are currently driven by uncertainty, rumors and especially a lack of financial transparency among banks. Unchecked, this loss of confidence will needlessly damage the economic outlook in the west, which was already slowing due to higher interest rates. I would prefer to see Bernanke (who is not being helped by Greenspan’s lack of candor) cut both the discount rate and the federal funds rate by 50 basis points tomorrow.

“The ECB, Fed and now the BoE have provided liquidity and indicated that they will continue to do so. However this is not enough, under the circumstances and moral high ground sermons from the ECB and BoE are not constructive during a credit crunch. A crisis of confidence also requires coordinated reassurances, daily if necessary, from central bankers and treasury ministers.”

Source: David Fuller, Fullermoney, September 17, 2007.

Asha Bangalore (Northern Trust): FOMC meeting – decisive and symbolic gesture
“The Federal Reserve lowered the federal funds rate 50 basis points to 4.75% and kept the spread between the discount rate and federal funds rate steady by cutting the discount rate also by 50 basis points to 5.25%. There were no dissents with regard to the cut in the federal funds rate.

“The policy statement has directed the focus of Fed action on the management of macroeconomic issues explicitly and reduced the importance of liquidity issues per se. By taking a two step approach after the onset of the current crisis, the Fed has sent a message that it is not in the business of bailing out excessive risk takers. The weak employment report of August played a major role in justifying today’s Fed action. By stating that ‘today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time,’ the Fed implicitly indicated that the reach of the housing market problem is wide and deep. Today’s Fed action should clear out some of the bottlenecks in money and credit markets gradually. Additional weak economic data will most likely translate into additional rate cuts in the months ahead. The key is weak economic data.”

Source: Asha Bangalore, Northern Trust’s Daily Global Commentary, September 19, 2007.

David Fuller: Comments after Fed’s rate cut
“This move will extend the credit super cycle, supporting asset markets in the process. Consequently odds that US stock market indices hold above their August lows have improved. This will lend support to most other stock markets, particularly where they have been under pressure recently. It will cushion downward risk in property markets. It will also support commodity markets by reducing recession fears. The US Dollar Index will extend its decline, at least testing historic lows. This is bullish for gold and other precious metals.

“I expect further rate cuts by the Fed, in 25 basis points increments. This will further dissuade the ECB and BoE from raising rates and some cuts are likely, if not this year in 2008. There will be an additional inflationary price to pay but probably not for the next year or two.

“Crucially, however, overall investment sentiment is no longer deteriorating following Ben Bernanke’s bold moves. Further cuts are necessary and I expect them, but the Fed Chairman has passed his first serious test with flying colors. And while it is easy to criticize the White House (many do so gratuitously), I am grateful for Hank Paulson’s presence as Treasury Secretary. If I were handing out grades for performance in this crisis, I would give the Fed an A (yes, I know it helped to create the problem), the ECB a B and the BoE a C. The BoJ’s grade is pending, but I fear may be worse.

“Assuming, as I do, that the vast majority of stock market indices have actually bottomed and that where recoveries have occurred the August lows will hold … the risk of a near-term repeat is low, exogenous shock aside. I continue to look for a benign 4Q 2007 environment, probably carrying well into at least 1Q 2008. It probably won’t be quite as strong as we have seen in the past, since investors and speculators will generally be more circumspect, but I look for additional gains. As always, watch for the Wall Street leash-effect, now joined by a China leash-effect which can only grow in terms of influence, particularly in Asia.

“Investors need a worry and as credit fears gradually wane, the legitimate financial concerns going forward will be food-led inflation, eventually pushing long-dated government bond yields above their May highs, and a weak USD which I maintain will eventually have to be rescued. Meanwhile, enjoy the ‘back from the brink of Armageddon’ (you may have noticed a degree of hyperbole from depressive bear types recently) window of opportunity in performing stock markets.”

Source: David Fuller, Fullermoney, September 18 & 21, 2007.

Richard Russell: Fed will avoid recession at all cost
“The Bernanke dilemma — move fast to avoid a recession — or attend to the swooning dollar. It’s no contest — the Fed will avoid a recession at all costs. The Fed has justified it’s action by announcing that there’s little or no danger of inflation, so why worry if we lower rates? To Bernanke, a recession means the possibility of deflation, and deflation is something Bernanke doesn’t want in his vocabulary.

“But there are problems. One is that the dollar is falling out of bed, and this has to be worrying our foreign friends, who hold tens of billions of securities all denominated in dollars. As the dollar sinks, our overseas friends are taking enormous losses. Should they sell their US holdings, should they stand pat and take it, or should they simply diversify out of dollars and hope for the best?”

Source: Richard Russell, Dow Theory Letters, September 21, 2007.

Richard Russell: No bear market or recession
“The Dow Jones Industrial Average is composed to thirty giant corporations, most of which enjoy a huge foreign presence. The value of these thirty giant stocks makes up about 25% of the value of all the stocks in the US. In other words, the Dow is big time, it’s powerful, it’s international, and it’s the trend-setter. The rest of the market can lag the Dow, the rest of the market may look rotten – but I’ve never in half a century seen a bear market in which the Dow was holding above preceding support. … since it’s August 16 low close, the Dow has been doing anything but breaking down! In fact, it’s been the strength of this market!

“The primary trend of the stock market is bullish. The secondary trend of the market is bullish. The stock market has discounted the worst that it can see ahead, and that’s enough for me. There isn’t going to be any housing disaster, there isn’t going to be any recession. Don’t get me wrong, there’s still going to be plenty of trouble for the people who are stuck with rotten mortgages, but the stock market is saying that the housing trouble is not going to flatten the economy. The stock market is saying that in due time the housing trouble will be put behind us.

“As long as the Dow holds above 12 845.78 there’s just NOT GOING TO BE ANY BEAR MARKET, AND THERE’S NOT GOING TO BE ANY RECESSION.”

Source: Richard Russell, Dow Theory Letters, September 18, 2007.

Gavekal: US dollar bulls harder to find than four-leafed clovers
“The current political atmosphere in the US has to weigh on the US dollar. Indeed, on the one hand is a lame-duck president without any political capital left, counting down the days to the end of his term and, on the other, various presidential candidates who are increasingly trying to outdo each other’s protectionist rhetoric (of both the traditional sort – i.e. ‘no foreign-made goods and no ‘exporting’ of US jobs’ – and the more modern sort – i.e. ‘no inward investments from China, the Middle-East, Russia etc…’). Add in fears of a military strike against Iran and the growing costs of the Iraq and Afghan wars, and it is enough to ensure that US dollar bulls become harder to find than four-leafed clovers.”

Source: Checking the Boxes, GaveKal Research, September 21, 2007.

Doug Casey: Sacrificing the US dollar
“In the currency market, the news went from bad to worse as the US dollar fell to new all time lows against the euro … after Wednesday’s brief rally. Late Thursday, the euro was trading at $1.4068 vs. $1.3958 on Wednesday.

“The buck also moved to one-to-one parity with the Canadian dollar, for the first time since November 1976. Even the British pound gained some ground, despite continuing fallout from the Northern Rock banking crisis.

‘The US dollar is clearly being sacrificed by the Federal Reserve in a last ditch effort to save the mortgage bankers,’ said Ned Schmidt, editor of the Value View Gold Report. “Schmidt added, coldly, that: ‘Foreign investors would be foolish to buy US investments knowing that the value of the dollar will decline.’”

Source: Doug Casey, Daily Resources Plus, September 21, 2007.

Peter Spina: Another nail in coffin of US dollar / Gold eyeing $800+.
“The 50 basis point cut by the Federal Reserve affirms their strategy of sacrificing the US dollar to keep the liquidity in the system alive. The decision is another nail in the coffin for the US dollar and will further extend the gold price rally. $800+ gold is headed our way in the coming weeks and months. Gold will continue to see a huge influx of investment demand.

“Gold is eyeing the all-time record highs from 1980’s which is around $850/ounce. Yet this is using 1980 dollars. Adjusting for inflation, gold has a way to go to reach its inflation-adjusted highs. We would have to see gold surpass $2 000 accounting for 27 years of dollar devaluation. That is a level becoming more likely as the current situation evolves, but likely years away.”

Source: Peter Spina, Goldforecaster.com, September 19 & 21, 2007.

Julian Phillips: Gold – it is an entirely new ball game
“Gold has broken out of all restraints now and is an entirely new ball game after Fed President Ben Benanke dropped interest rates at the expense of the dollar’s value internationally. National interests will always override international ones. Only confidence in the US economy, its banks and the ability of the consumer to spend will restore confidence to former levels and confidence in the dollar and turn gold’s price down again. Will this happen?”

Source: Julian Phillips, Goldforecaster.com, September 21, 2007

Doug Casey: Spain to stop selling gold
“The Hightower Report … wrote: ‘While the gold market didn’t seem to drive higher into the close a double digit gain for most of the session is still a very impressive move for the bull camp. With the US dollar under significant and historic selling pressure it isn’t surprising that gold is being viewed as a safe haven investment. With the Treasury market also surprising the trade with an aggressive downside thrust on Thursday it would certainly seem like there are markets other than gold that are seeing the prospect of soaring inflation.’”

“… another positive (for gold) was Bank of Spain Governor Miguel Angel Fernandez Ordonez, who said the Spanish central bank won’t be selling any more gold this year. While hard figures are difficult to come by, most reports have tabbed Spain as the largest seller of gold this year, with some 165 tonnes unloaded.”

Source: Doug Casey, Daily Resources Plus, September 19 & 21, 2007.

Gavekal: Collapse of credit could still be in front of us
“In the third quarter, banks have been forced to expand their balance sheets way beyond what they wanted to do. Indeed, as the credit markets seized up, and as conduits and SIVs ran into trouble, credit lines were tapped massively.

“Following this summer’s events, legislators and regulators will be anxious to ‘close the barn doors,’ even if all of the horses have escaped. For example, it is likely that Mervyn King was not too happy to be forced to perform a massively embarrassing about-face in order to save Northern Rock. One should thus expect that … underlings are being told to tighten up the monitoring of what the banks are up to.

“With this in mind, it is hard to avoid the conclusion that banks will start cleaning up their balance sheets and be much more conservative in the coming quarters. In other words, the collapse of credit in the West could still be in front of us.

“This simple fact helps explain why the Fed decided to act aggressively yesterday. Historically, the Fed has tended to act counter to whatever the banks were doing (when banks lend more, the Fed raises rates, and visa versa). Yesterday, however, the Fed decided to lower rates at a time when commercial bank lending was growing at the fastest pace since 1987.”

Source: Checking the Boxes, GaveKal Research, September 19, 2007.

Asha Bangalore (Northern Trust): Dismal outlook for housing sector
“The outlook for the housing sector remains dismal. Yesterday, the National Association of Home Builders published the Housing Market Index for September, which dropped to 20.0, matching the record low reading of January 1991. The index tracking single-family sales six months ahead established a new low of 26.0. Indexes tracking current sales and traffic of prospective buyers fell to 20.0 and 16.0, respectively, which now match the respective record low readings for both series.”

Source: Asha Bangalore, Northern Trust’s Daily Global Commentary, September 19, 2007.

John Mauldin: I still think recession
“Even with a proactive Fed, I think we do not avoid a recession. I think the Fed did the right thing by cutting rates. I think they will cut them more as the economy continues to slow. We will see a Fed funds rate with a “3 handle” before this process is over (meaning that the Fed funds rate starts with a 3 from the current 4.75%). The Fed did not start down this road with the thought 50 basis points would be enough.

“The point is to try and drop rates enough to make mortgages (when that market finally rights itself) low enough that home buyers can afford to buy homes. While that will help some individuals, the more important concern from a central bankers perspective is the total economy. You do not allow the housing market to implode on your watch and do nothing. And yes, it will help business with lower funding costs and encourage deals and risk taking. Which is what you want when an economy is on the verge of recession.

“But home construction, even with lower rates, is not going to turn around fast. At the peak of the market, we were building 2,000,000 new homes a year in the US. As the following chart from the Conference Board shows (thanks to Dennis Gartman), it is not unusual for housing starts to drop below 1,000,000, and this typically precedes a recession.

Source: John Mauldin, Thoughts from the Frontline, September 21, 2007.

Economy.com: Probability of a recession
“The probability of a recession for the United States rose sharply in August, reflecting the turmoil in global financial markets. In August, the probability of recession jumped to 40%, up from July’s 15% and its highest since 2001. The risks to the US economy increased appreciably in August led by tighter credit conditions, rising mortgage delinquencies, turbulence in global financial markets and weakening housing markets.”

Source: Moody’s Economy.com, September 19, 2007.

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5 comments to Words from the wise for the week that was (Sept 17 – 23, 2007)

  • Yannick

    Hi,

    First of all I would like to thank you for this weekly letter that I would not miss for now.

    I have a question related to your sentence “Bernanke’s opening of the floodgate of liquidity calmed stock markets” but which is something that I am thinking about since I read John Hussman words about the real role of the FED.

    How can a 0.5% lower interest rate in the FED FUNDS RATE have any influence on the real economy as this interest rate (Overnight) only applies to something like 1.4 billions $ of excess reserves (which are 41 billions $ in september 13th*) and 2.25 billions $ at discount rates (FED FUNDS RATE + 0.5%) ? (taking in account that the reserve obligation applies only to checking account since december 1990)

    Thank you for your explanation

    Regards

    * http://www.federalreserve.gov/Releases/H3/20070913/h3.pdf

  • Bob

    Yannick,

    I was wondering about Hussman’s claim, too. I am under the impression that in general banks set their prime lending rate relative to the Fed Funds rate – for example, many banks lowered their rate 1/2% on Tuesday. Many of their other loans are priced relative to their prime rate. So while the Fed may not have direct control, they seem to have much more than the mere psychological effect claimed by Hussman. But Hussman is a really smart guy, so I was left with a good deal of cognitive dissonance.

    Regards

  • Mr. Obvious

    Fellows,

    I have a couple of thoughts for your consideration. First, perception is often more important than reality. Second, historically rate cutting/hiking cycles have been more closely correlated with equity bull/bear markets; thus, the phrase, “don’t fight the Fed.” Third, it may be that a MUCH lower Fed Funds rate really does have an impact on the real economy. If so, then this change at the margin suggests that we will eventually get the much lower FF rate, since as John Mauldin points out, the Fed usually ends up cutting/hiking for far longer than market participants expect.

  • Patrick Waterson

    Baie dankie – lekker om te lees.

  • Prieur,
    Truly an informative blog… will be checking in here as often as possible and sending my dad a link to this site as well. Thank you for the depth of your posts-
    Jonathan.

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