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Five Things You Need to Know: Fed Was Snookered, Not by Societe Generale, by Economy


Excellent, "low-risk buying opportunities" have never made much sense at the time, and always feel like the worst, highest-risk buying opportunities.


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Conspiracy of Dunces

There are only two concepts one needs to grasp to understand all of Wall Street: herding behavior and raw emotion. Everything else is window dressing, both literally and (at month's end) figuratively.

For evidence of this, consider the following:

After an unnamed Federal Reserve official said yesterday that the U.S. central bank didn't know of Société Générale's rogue trader problem when the Fed cut rates Tuesday morning, everyone somehow completely forgot the past six months of credit market turmoil and the worst January ever for stocks that brought us to last weekend, mysteriously choosing instead to adopt the "Fed Was Hoodwinked" explanatory paradigm. Truly, that explanation would require a vast conspiracy of dunces.

Herding Behavior

2. Snookered?

"It does look like they were snookered into cutting rates," Lou Crandall, chief economist at research firm Wrightson ICAP LLC, told the Wall Street Journal in response to a question about the Fed's Tuesday rate cut.

Snookered? By a Société Générale rogue trader? I don't think so. If the Fed really was "snookered," it was "snookered" by any number of the following that are absolutely not related to a Société Générale rogue trader:

  • More than $100 billion in writedowns (so far) related directly to subprime mortgages, including $22.4 billion from Merrill Lynch (MER), $19.9 billion from Citigroup (C), $14.4 billion from UBS (UBS) and $9.4 billion from Morgan Stanley (MS).
  • From the July peak, a stunning $340 billion, or 15.6%, collapse in total commercial paper, a decline of unprecedented magnitude (see chart below):

  • A $1.2 billion third quarter loss by Countrywide Financial (CFC), the nation's largest mortgage lender, the first loss for the company in 25 years.
  • A 1.4% drop nationally in the median price of a home, the first national drop since the Great Depression.
  • A 70% year-over-year increase in homes in some stage of foreclosure, per the latest data available from the Mortgage Bankers Association.
  • A 25% decline nationally in housing starts, the steepest decline since 1980.
  • Tighter credit standards for businesses and consumers despite a reduction in interest rates.
  • A loss of 61,800 residential construction jobs, according to the Bureau of Labor Statistics.

3. The Bernanke Put

The Wall Street Journal, however, seems intent on pursuing the "Fed was snookered" angle: "The Fed has long argued that it only responds to stock prices insofar as they affect the economic outlook. Nonetheless, critics say its hastiness under former Chairman Alan Greenspan to ease when markets quaked amounted to a "Greenspan put," similar to a put option that protects investors against loss. There is now a "Bernanke put," they say."

Yes, there is a Bernanke Put, which we detailed in May of last year. But unlike the Greenspan put, the Bernanke Put is not a stock market put in so far as stocks are decoupled from deflation. It's a pure deflation put. And what the Federal Reserve is facing is a deflationary credit contraction. This is not directly about the stock market.

4. It's Not About the Stock Market

How can I be so sure? Well, consider this perspective. A couple of days ago I was part of the following conversation after work at a happy hour spot:

Person 1: Look, it's just not that bad out there. So the stock market is off a little, big deal.
Person 2: (Pulling up a two-year chart of the S&P 500 on his phone) Yep, look at this. We're right back at late 2006 levels. Not bad at all.
Me: Or, you could look at it another way. We're only a couple of percent below late 1999 levels.
Person 1: What do you mean?
Me: (I drew a U-shape in the air with my finger.)
Person 1: Ah... yeah, I forgot about that.
Me: The good news is over the last eight years, S&P 500 investors have only lost about half a percent a year on average.

Herding behavior and emotion. That's why it's so easy to forget where we've come from, and all we really need to grasp to understand Wall Street.

5. And Now, for the Good News...

The good news is that nothing goes down in a straight line, and the bullish percent indicators for equities we follow are showing some light at the end of the tunnel. With yesterday's action the bullish percent indicators for the S&P 500 and Nasdaq-100 both reversed up to positive from extraordinarily low levels.

The chart below, courtesy of Investor's Intelligence, shows where the S&P 500 Bullish Percent currently resides. Historically, reversals up from these low levels have been excellent, low-risk buying opportunities. Keep in mind, those "excellent, low-risk buying opportunities" have never made much sense at the time, and always feel like the worst, highest-risk buying opportunities. But I guess that's what makes them so good. They tend to run opposite herding behavior and operate outside of emotion.

S&P 500 Bullish Percent (Chart courtesy Investors Intelligence)

No positions in stocks mentioned.

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