Editor's Note

09/20/2007 12:00 am EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

September 20, 2007

On Tuesday afternoon, Ben Bernanke gave the “all-clear” signal. When the Federal Open Market Committee cut the federal funds rate by a surprisingly high ½ point to 4.75%—and lowered the discount rate another half-point to boot—the central bank was making a clear statement: this summer’s financial crisis is officially over.

So, you now have the US government’s permission to buy stocks again.

“Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time,” the FOMC’s much-parsed statement read. 

As if that weren’t enough, earnings reports from major Wall Street investment firms showed big losses, to be sure, but nothing way out of line: charges related to the mortgage meltdown ranged from $700 million to $1.5 billion this quarter. That assumes, of course, that Lehman Brothers, Morgan Stanley, Goldman Sachs, and Bear Stearns aren’t engaged in wildly creative accounting—which would be insane under these circumstances.

“I think the worst of this credit correction is behind us,” Christopher O’Meara, Lehman’s chief financial officer, told analysts on Tuesday’s conference call.

Noting that previous “dislocations” lasted three months on average, O’Meara said, “in the past, central bank actions have served to reestablish investor confidence while higher yields eventually attract buyers to the markets.”

In other words, the Fed has fulfilled its classic mission of “lender of last resort,” as we explained here a month ago. That piece also said the worst of the financial panic was over and suggested that the Fed’s first cut in the discount rate was a good buying opportunity for stocks.

Nor was this any surprise to our MoneyShow.com users. Just three weeks ago, in our most recent Investor Sentiment Index, two-thirds of our respondents expected lower short-term interest rates and higher stock prices this year.

Meanwhile, in the real world, Best Buy, the nation’s largest consumer electronics retailer, reported much better-than-expected earnings in the second quarter and boosted its earnings guidance for 2007.

Same-store sales rose a respectable 3.6% as Americans (and especially Canadians) gobbled up video games, notebook computers, and flat-screen televisions.

Thursday, FedEx also reported better-than-expected earnings, but lowered its target for the rest of the year.

Hey, nobody said the US economy was firing on all cylinders—and it was precisely this economic weakness that gave Bernanke & Co. their rationale for cutting rates.

But it’s also clear that American consumers aren’t quite ready to put on their hair shirts and live in caves while they watch the values of their homes plummet—as some of the permabears want us to believe.

So, what’s next? Here’s what the FOMC’s statement said: “The Committee will continue to assess the effects of [developments in financial markets and] economic prospects and will act as needed to foster price stability and sustainable economic growth.

”Translation: if the housing market continues to weaken and there are still periodic subprime blowups in unexpected places (both of which are likely), then the Fed will cut rates again.

That’s good news for stocks, which are pausing Thursday after a big rally that drove the Dow Jones Industrial Average and the Standard & Poor’s 500 to within 2% of their all-time highs set in mid-July. Look for both indexes to easily break those records by year-end.

We’re also likely to see a rebound in some of the more speculative and interest-sensitive asset classes that have gotten their comeuppance in recent weeks (and which this column recommended dumping back in March.)

Real estate investment trusts, emerging-market bonds, and high-yield corporate bonds have rallied, particularly in response to the Fed’s rate cut. And the iShares MSCI Emerging Markets index (EEM), which tracks emerging-market stocks, is up nearly 7% since Tuesday morning.

But I don’t expect REITs and high-yield bonds to come back all the way: this is at best a relief rally, and times have clearly changed. The Fed may have eased, but the risk-free party we’ve enjoyed for the last few years is gone forever. Investors will demand more protection, deals will get scrutinized much more closely, and some won’t get done at all.

Since the Fed made its dramatic cut, some people have complained that it would bail out people who made bad decisions and thereby reward and encourage reckless behavior—the classic problem of “moral hazard.

” We heard this back in 1998, when the New York Fed organized a group of major financial institutions to carry out a real bailout of Long-Term Capital Management, as I wrote here (subscription required).

I happen to think many hedge funds that made those bad bets this summer are struggling with big redemptions, and some of them may have been short the S&P 500 when the Fed’s announcement came. Some bailout!

More importantly, however, it’s easy to take a morally consistent position in a vacuum. But if you’re making decisions that affect millions of people, it’s a whole other story. No responsible central banker would risk letting a financial panic become a full-fledged crash and severe recession—especially in a democratic society.

That’s why the Bank of England has just reversed its much-publicized “tough-love” stance by agreeing to provide ten billion pounds to cash-strapped mortgage lenders in response to the recent run on Northern Rock bank. It also wouldn’t surprise me to see it and the European Central Bank hold the line on rates, or even cut them along with their American counterparts.

The sight of hundreds of depositors queuing up for hours outside the branches of Britain’s fifth-largest mortgage lender is enough to put the fear of the Lord in anybody.

Comments? Please email us at TopProsTopPicks@intershow.com.

Howard R. Gold is editor-in-chief of MoneyShow.com. The views expressed here are his own and are not necessarily those of InterShow.
 

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