Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Fed Is Between a Rock and a Hard Place
04/03/2007 12:00 am EST
James Stack, president of InvesTech Research, claims that the Federal Reserve is tougher on inflation than investors believe, and may have a tough time engineering the “soft landing” in the economy that Wall Street expects.
Note that in the latest release, the Federal Reserve no longer makes reference to “stabilization” in the housing market. Our contention has been that no one knows how deep or how long the unwinding will last, as evidenced by the diverging opinions even from “experts” in the industry.
Also, in January the Fed felt that core inflation had “improved modestly,” but now they refer to inflation as “somewhat elevated.” In fact, the core Consumer Price Index (excluding food and energy) has not moderated and remains near a ten-year high. The jump in owner’s equivalent rent, a major component of the core CPI (24%), has been a big factor.
Our view is that the Fed has not softened its inflation stance. In fact, the March 21st statement is about the strongest rhetoric possible without actually adopting a tightening bias. The words have changed, but the message hasn’t: The Fed is caught balancing between housing weakness and inflationary pressures. While we believe this market deserves the benefit of a doubt, don’t abandon caution. The recent jubilation could be short-lived.
In a correction-less market, volatility can come from nowhere, and the last few weeks have produced wild market swings. On two separate days the Dow Jones Industrial Average lost well over 200 points, taking our Pressure Factor to extremely rare oversold levels [at which] a rally of some sort would normally be expected to materialize. Therefore, we shouldn’t be surprised by the market’s rise following the Federal Open Market Committee’s meeting.
As mentioned earlier, we continue to give this bull market the benefit of the doubt – for the following reasons:
1. Our technical models are not yet deteriorating, as we’d expect if a bear market were imminent. Breadth is stable, and there’s been no significant increase in downside leadership.
2. While the historical odds are low that the Fed will be successful in navigating a soft landing (only 20%), it’s still possible and we should allow for that by focusing investments in defensive sectors and stocks.
However, risks remain:
1. The housing market is a big wild card, and there’s a dichotomy of opinions on where this industry is headed. Our Housing Bubble Bellwether index has fallen sharply, and if it breaks through last year’s support levels, the risk of a bear market and recession will increase dramatically.
2. Inflationary pressures remain, and we don’t view the FOMC’s rhetoric as favorably as Wall Street did. Economic reports are mixed, and further Fed tightening could still be in store.
Until these longer-term risks disappear, we’ll continue to step softly and carry a healthy cash reserve.