Fed monetary policy: Back to the drawing board!

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After the cut in the discount rate, markets are longing for rate cut in September

First, I do not regard the current market conditions to be unusual but I do consider the market conditions that preceded the current correction (the period between March 2003 & July 2007) to have been unusual since they were characterised by extremely low volatility and a relentless increase in all asset prices. Compare the recent low volatility bull market to the conditions in the 70s!

We had, in the 1970s, every year, huge market swings. Therefore, what is unusual about the present is how just a minor correction of 10% could create so many problems among hedge funds and other financial institutions and how it led to calls by some ‘experts’ for the Fed to cut rates. This, especially in light of the fact, that it is precisely the Fed’s expansionary monetary policies, which have led to the current problems in the credit markets. However, it is indicative of the rot and the leverage, which are nowadays endemic to the global financial markets.

In my view, the current correction is of course, a minor one, when compared to the 1987 or 1998 corrections.

But, as was the case in 1987 & 1998, the stock market became, after an initial decline, as of August 16, 2007, from a near term perspective, incredibly oversold. On that day, the Dow first sold off more than 300 points, but ended the session basically unchanged. On the same day, we had on the NYSE only 10 stocks hitting 52 weeks new highs, but a staggering 1,045 stocks reaching new lows.

On August 17, the S&P 500 soared 34 points and the Dow Jones 233 points, as the Fed cut the discount rate. However, 52 weeks new highs expanded to only 55 and were outpaced by 149 new lows, which is unusual during such a powerful upward move. Personally, I am not surprised that the Fed cut the discount rate and injected liquidity into the system by moving the Fed fund rate below the target rate of 5.25%. I have repeatedly maintained that should Goldman Sachs’ stock decline by 20% off its high, the Fed would cut rates under pressure from the now ‘impoverished’ Wall Street jackals. I am also not surprised by the strong rally from the August 16 intra-day low because investors are still conditioned to buy the dips and not to sell into strength. I regard the fear to miss the next advance to be negative for the market from a contrarian point of view.

My best guess is that we have seen an intermediate low, but that the S&P 500, which, as at last week’s close, was still down 100 points from its July 2007 high, will have great difficulties to make a new yearly high. A very strong overhead resistance now exists between 1,500 & 1,540. Therefore, I would use additional strength as a selling opportunity. It is also my view that, in time, the recent August low and the March 2007 low at 1,363 will be taken out on the downside.

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Source : IIPM Editorial, 2007

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