The Well-Timed Strategy

Economic & Stock Market Analysis for the Discerning Investor & Executive

www.peternavarro.com

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Announcements: Click here for my Feb 7 testimony before the US-China Commission and the testimony of other participants.  It was a very thoughtful hearing and a good primer on the subject.

This Week: The Fed is Dead

I still find it puzzling that so many Wall Street analysts let hope -- and a built-in bias for the long side of the market -- get in the way of economic fundamentals and technical realities.  Removing this filter of misplaced hope, it should be clear that the US markets are in a cyclical bear trend.  The only really big and interesting question now is whether this cyclical trend will morph into a secular bear market -- one  that might turn out to look uncomfortably like the stagflation days of the 1970s.

The grimmest economic fundamental is that monetary policy is very close to, or has already reached, the point not just of being ineffective but also counterproductive.  The root of this problem is that US interest rate policy is at odds with virtually every other part of the globe, particularly Europe and Asia which, because of inflationary considerations, have a bias towards raising, rather than lowering rates.

The Fed's conundrum is this: every time it cuts short-term rates, it hopes that the bond market will react collectively by pushing down long-term yields.  When the Fed is effective in influencing the long end of the yield curve, it has its only chance of stimulating consumption and investment.  The problem now is that the bond market is not cooperating.

Traditionally, if the bond market is a net seller when the Fed cuts rates, the bond market is fearing that the Fed rate cuts will be too stimulative and therefore fan inflation.  In this scenario, savvy bond investors do not want to be locked into current yields because they know that inflation will drive those yields up in bond prices down.  Therefore, the bond market faces net selling -- and yields rise on inflationary expectations.

In the new globalization paradigm, however, bond investors are looking at something entirely different -- the declining dollar.  In a world in which the Fed continues to cut interest rates, inflationary pressures in Europe make it very difficult for the European Central Bank to match the Fed rate cuts.  At the same time, in Asian countries like China and Australia, these countries are actually raising interest rates to rein in inflation.  The only possible net result of this divergence in global monetary policy is a falling dollar.  A falling dollar in turn fans inflationary flames in the US because it makes imports more expensive -- particularly oil.  So now when the Fed cuts interest rates, the long bond market is starting to get very nervous about inflation driven by a falling dollar.  Embodied in this year is the clear understanding that any benefits of a falling dollar related to stimulating exports and economic growth will be more than offset by the inflationary effects caused by the falling dollar and rising import costs.

I might note here that there is no world oil price shock in progress.  It is a US oil price shock.  As the dollar has fallen against the euro, Europeans are actually paying about the equivalent of $50 a barrel oil.

The bottom economic fundamental line is this: Wall Street is all over Ben Bernanke to cut rates more and for not cutting rates fast enough.  Each time the Fed cuts rates, the markets get a bit of a bounce.  However, on the bounce, the smart money is selling the rallies because they understand the flip side of the money.  This flip side is inflation, a growing ineffectiveness US monetary policy, and in emerging possible stagflation scenario.  Why so many Wall Street pundits don't see this is again puzzling.

As for technical considerations driving the US stock market, when I look at a chart of the S&P 500, it shows a very clear downward trend along with a double top and, for the more imaginative, a weak head and shoulders pattern.  Nobody with any technical training is going to be a buy and hold investor in that market.

The perennial question of course is how to make money in these current conditions.  The short side is difficult even though the market is in a downward trend because of the extreme risk of a variety of government bail outs around the world.  As for the long side, the best opportunities are going to come to those chess players who can figure out which companies are going to be targets of deep pockets ranging from Warren Buffet to sovereign wealth funds.