It has been almost ten full months now since the Fed first lowered interest rates. If you remember at first there was a lot excitement over the Fed cuts. The DOW and Nasdaq rallied to new 52-week highs a few weeks after the first rate cut in September. The rally and promise of more Fed intervention for the market made many big name commentators extremely optimistic about the market.
But just a few weeks later the market turned lower and has been stuck in a bear market ever since. The banking problems multiplied and inflation skyrocketed with oil rising almost double in price now from where it was a year ago. The rate cuts tasted good at first, but are no longer palatable.
When thinking about the financial markets sometimes it is best to take stock of things before trying to look ahead and decide if you need to make changes to your portfolio or figure out where to look for the best investment opportunities. I think a lot can be learned about looking at where the market was a year ago and comparing it to today.
A year ago from today the DOW, S&P 500, and Nasdaq were all climbing higher. They had experienced a fast and furious correction that took the S&P 500 down over seven percent in February of 2007. The financial media blamed that quick correction on "credit worries," a fast drop in the dollar versus the yen, and a huge correction in the Chinese stock market. Rumors also circulated that some billion dollar Bear Stearns hedge funds were in trouble.
Over the next few months as the market went higher everyone thought that all of these problems were gone. Then the financial press started to focus on oil prices that were making new highs and the threat to inflation that they posed. In July the market peaked as talk intensified that the Fed might actually start to raise interest rates by the end of the year. Indeed Fed fund futures a year ago were pricing in rates hikes by the end of 2007.
Fed officials gave repeated speeches and statements that sounded hawkish on interest rates. At the same time though the drop in real estate prices started to pick up and the value in "subprime" mortgage securities went into collapse. Rumors abounded that several large hedge funds were in trouble.
The Fed publicly ignored all of this. At its August FOMC meeting they released a more hawkish statement on inflation to prepare the way to raise rates. The market dropped hard that day and James Cramer blasted the Federal Reserve and Ben Bernanke on TV for knowing "nothing." His statement was one of the most watched moments in financial TV reporting as people watched it millions of times on the Internet.
At that moment he was right. Within two weeks the market went into a mini-crash and the Federal Reserve lowered the discount rate in what looked like a panic move. The value of "subprime" securities went to zero. They are still being counted as "level three" assets on the balance sheets of some of the world's largest banks but in reality they are worthless and have been worthless since last August.
The Fed changed course 180% degrees in August and began to slash rates in September. It continued its rate cutting campaign and has lowered rates in the past ten months at the fastest rate than it ever has before in history - faster than it did even during the Great Depression.
Since then we have seen the "credit crisis" worsen. We have seen the economy slow down, real estate prices continue to drop, inflation explode, and the Fed print about 30 billion dollars and hand that money to JP Morgan so that it could buy Bear Stearns and prevent a potential systemic bank run.
What a roller coaster! And it ain't over yet folks. You can expect to see more volatility and the overall downward bias in the financial markets to continue the rest of the year.
What I want you to do right now though is think about the situation last year and how it compares with today. Just like in June of 2007, right now we can look back on this year and see a big correction behind us. Just like the correction in February of 2007, this one we saw in the first quarter was linked to credit problems and the unwinding of the real estate bubble. And just like then we have seen the market rally after that correction and lots of big name experts come out and declare the worst behind us. For instance Abby Cohen of Goldman Sachs claims that there is going to be a second half economic boom that will make the stock market rise much higher than it is now into the end of the year.
Things are certainly different right now than they were last year. The US is in a bear market right now whereas last year it was approaching the tail end of a cyclical bull market. That is a huge difference. But there is one important similarity that you need to focus on right now. At this time last year most people were worried about inflation and were expecting the Fed to raise rates by the end of 2007. Right now everyone is worried about inflation and the Fed has talked very hawkish about inflation over the past few weeks. Most of the talking heads are looking for the Fed to raise rates by the end of the year. This is exactly the same spot we were in this time last year!
But what if the economy doesn't pick up steam in the second half of the year and the stock market continues lower? What if more banking problems materialize? Bank stocks are making new 52-week lows and have been falling fast this month. They do not seem to be forecasting an end to the credit crunch. And really they shouldn't, because there is no sign of a bottom in real estate and all indicators I follow suggest that we won't see one into at least the second half of 2009.
I think we are likely to see a Fall shock hit the market. Last year we saw the Fed do a 180 degree turn from talking about inflation to cutting rates like a mad hatter. This year I believe we will see the Fed abandon its talk of fighting inflation to once again intervening to bail out some bank, patch up the leaky economy, or in response to a stock market mini-crash. I think the situation right now is like it was a year ago - everyone is worried about inflation, but the real problems lurk in the cooked books the banks are carrying. In fact we are more likely to see more problems emerge and the stock market go lower as that is the primary trend right now.
In essence the Fed is playing a game of poker. It is bluffing when it says it is fighting inflation. It has no chips left and has bet everything on the slim chance that the economy has already bottomed. If something happens to make the Fed intervene again then it will be faced with a choice of fighting inflation by raising rates, which would have the effect of blowing up the banking system, or intervening to save the banking system, the economy, and the stock market, which of course would mean more inflation, a falling dollar, and falling bond prices. The Fed has proven that if it gets trapped into such a corner it will side to help the banks and the stock market a stable currency be damned.
If this is what we see happen in the Fall then the Fed will lose all of its credibility when it comes to maintaining a stable currency.
What do you need to do? You need to do what you should always be doing - keeping your pulse on market trends to figure out the best way to position yourself to make money is. You can profit from any situation. Right now we have a bear market and that means using bear market strategies.
I will leave you with one last thought for today. In the past ten years every time the Fed has gone on a campaign of lowering interest rates it has create a "bubble". In 1998 the Fed lowered rates to bailout the Long-Term Capital Management Fund. When it did so it put excess money into the banking system. There was a lack of good investments for that money to go into so it flowed into Internet and tech stocks and formed a bubble. When that bubble burst the Fed lowered rates again to try to make the stock market go back up. As a result they dropped interest rates to an artificially low point, which created a housing bubble.
We are now suffering through the fallout of the housing bubble - the direct result is a recession, bear stock market, and "credit crisis" from banks who went nuts during the bubble.
Now remember - every time the Fed cuts rates it creates a bubble, because it puts excess money into the economy.
Well, the bubble now is now in commodities and oil. A direct result is inflation, a falling dollar, and eventually a bear market in bonds. There are opportunities to profit from this and I believe gold and precious metal stocks will be the best way to go. If the Fed abandons this current inflation fighting talk this Fall I expect we'll see gold prices skyrocket into the end of the year.
Of course this is looking ahead and that isn't always an easy thing to do when it comes to the stock market. I can't say with certainty that this is going to happen. But I do know the technical signs in the market that will appear over the next two months if this is indeed what is going to happen and I know how I will position myself. The next eight weeks are going to be some of the most important we've ever seen in the financial markets. Not because of what will happen during these weeks, but to see how the markets are positioned once they are over. As any technical signs appear to point us the way I will draw your attention to them and explain to you exactly what they mean so that you can take advantage of anything that may happen too. From chaos comes opportunity and opportunity is another way to spell profits.
This article is an excerpt from today's weekly WSW Power Investor market commentary. The full article contains more chart analysis of the market and a focus on ETF trading positions and several gold stocks today.
About author Mike Swanson is the founder and chief editor of WallStreetWindow. He began investing and trading in 1997 and achieved a return in excess of 800% from 1997 to 2001. In 2002 he won second place in the 2002 Robbins Trading Contest and ran a hedge fund from 2003 to 2006 that generated a return of over 78% for its investors during that time frame. In 2005 out of 3,621 hedge funds tracked by HedgeFund.Net only 35 other funds had a better return that year. Mike holds a Masters Degree in history from the University of Virginia and has a knowledge of the history and political economy of the United States and the world financial markets. Besides writing about financial matters he is also working on a history of the state of Virginia. To subscribe to his free stock market newsletter click here.