Vad's Best Ideas

"In matters of style swim with the current, in matters of principle-stand like a rock"
Thomas Jefferson

I think the next few weeks will determine the direction of where the world largest economy will be heading for the next few years. If you read most of the mainstream press it sounds like this direction is clear- series of rate cuts, followed by shallow recession and bright future. Not so fast...It's definitely easy to be a politician and make it look like all of the world's economic problems could be magically wiped off the face of the Earth by a swift downward hand movement by a wizard called Ben Bernanke...

The truth, as usual, is that popular opinions always swing too far. Rate cuts are rarely followed by a period of short term market out performance and thus problems will not just simply go away. What's more in most recent rate cut cycles the decisions when to start cutting were relatively simple (9.11, debt crisis etc) and most of the time were on target. The more difficult decision is when to stop cutting rates and that's were we might've had less success with the outcome- at least some of the current problems are due to what many believe was one of the few mistakes Alan Greenspan has made- cutting rates too low.

This time Ben's decision is neither easy nor warranted by a consistent pool of homogenous data. There wasn't a major stock market crash(10% is decline is merely a correction), corporate earnings are still climbing (albeit very slowly). What's more oil has just hit a new all time high today, copper is pushing multi months highs, wheat is at all time high as well. Inflation overall is still stubbornly high and is above or in the higher range of the desired 1-2% corridor; dollar is pushing all time lows against the euro, Chinese bubble is only getting fluffier every day, rents are still climbing, consumers are still spending... So in short the data for a significant series of rate cuts is not there ( I do anticipate that recession is likely to occur in the next 12-18 months one way or another)

The question now is whether all of the above is just a lagging indicator of the irrational behavior from the excesses of the last five years. Liquidity struggles of the last six weeks have not yet been resolved completely even though normality is slowly coming back into the financial system. So the real issue is whether Ben is going to bow under pressure and will swim with the current of the "cutting mood" or will he acknowledge that maintaining price stability is the most important role that Fed plays and that buckling under popular pressure is the easiest way for introducing unnecessary volatility and excesses into the otherwise well functioning Economic machine. Inflation beast has not been defeated yet and until it happens everything else (growth or unemployment) is less relevant

Playing with size of Cap of Freddie's and Fannie's mortgage portfolios, accepting new forms of collateral for the Repo agreements as well as introducing new regulation into the lending world are purely matters of style and thus in this case my advice for Ben would be to swim with the current. Let politicians have their time in the light- it's not worth fighting over.

However maintaining price stability IS the matter of PRINCIPLE and standing like a rock is the only appropriate stance that Ben Bernanke should take.

Now going back to business- as I said before my expectation that Fed while could cut rates (25BP) next week but I would expect that the screamers could be disappointed that the cuts don't go far enough and the overall market will sell off. Thus while I still have some Rate cut exposure (subprime) I am repositioning it into slightly lower volatility picks- I sold NFI (double digit gain) and IMB (small gain) today and replaced them with CFC and FMT.

Both of my new picks have deviated from the overall Subprime group in the last few days and now it is time to regress back to the mean again.

P.S. Oil is getting frothier by the day and I think absent major supply shocks in the form of the hurricane or a terrorist act we are up for a significant correction in the next few months...

Trade safe and cheers,
Vad

Comments: View Comments |  Wednesday September 12, 2007