Pre-emptive Cut Should Help

Today’s news from the Fed provides good reason for why I don’t write the Brief in advance. We collect data all week and I assemble thoughts along the way, but economic winds can occasionally shift so fast that yesterday’s news literally becomes antiquated. A large portion of today’s topic would have been devoted to speculation of the Fed’s next action. Well, this morning they answered the question without ambiguity. 

Today, the Federal Reserve unexpectedly cut the rate at which it makes direct loans to banks by .5% to 5.75% and said they are prepared to take further action to “mitigate” damage to the economy from the rout in global credit markets. Bloomberg notes it’s the first reduction in borrowing costs between scheduled meetings of the Federal Open Market Committee since 2001 and Ben S. Bernanke’s first as Fed chairman. 

The statement, which accompanies the move, reflects a dramatic shift in the thinking of the FOMC. “Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. “The downside risks have increased appreciably.” They added that they are “prepared to act as needed to mitigate the adverse effects on the economy arising from disruptions in financial markets.” The statement is dramatic because as recently as its Aug. 7th meeting, the FOMC kept rates unchanged and said inflation is still the biggest danger to the economy. 

Just yesterday, St. Louis Fed President William Poole said only a “calamity” would justify an interest-rate cut. Apparently the Fed saw such a calamity coming as they likely compared today to the 1998 freezing-up of Treasury markets caused by the hedge fund Long Term Capital and Russian debt default. The US economy was ok then too.

This is the first time this Fed, under the direction of Mr. Bernanke, has acted preemptively; ahead of the data. As such, we expect they will be considerably more constrained with future rate reductions. To take rates down significantly from here might simply prolong the mortgage problem, and push the comeuppance into the future. Clearly though, they saw a larger systemic problem brewing. 

And today’s action was not their first. The Fed had already introduced a temporary reduction in interest rates by driving the four-week Treasury bill below the Fed funds target on Wednesday. In a research paper, Charles Diebel, a strategist at Nomura International inLondonpointed out that “it is clear that a ‘temporary’ easing has been put in place by the Fed. This is what has really spooked markets overnight.” (Wednesday night and the following Thursday) The four-week bill rate declined to 4%, well below the Fed’s target of 5.25%. “If this artificial suppression of short-term rates has to be maintained, which we suspect it will, then the Fed will eventually formalize the de facto ease with a move lower in the official target,” Diebel wrote. “It is likely to be at least a 50 basis-point move if and when it comes.” Well done Mr. Diebel. 

Stock markets around the world reacted positively to the news. European stocks jumped the most in four years. And if you will pardon a slightly mixed metaphor, Vafa Ahmadi, a fund manager at CPR Asset Management inParissummed it up pretty well by saying “This is good news for stocks. This [Fed action] provides more liquidity to a market that needs it terribly. It’s a bowl of oxygen to those who couldn’t refinance.” 

National benchmarks rose in all of the 18 western European markets, according to Bloomberg. TheU.K.’s FTSE 100 added 3.4%.France’s CAC 40 rose 3% andGermany’s DAX advanced 2.3%. The Stoxx 50 advanced 3.1% today, while the Euro Stoxx 50, a measure for the Euro region, gained 3%. At the moment the Dow is up 200 points or 1.5% and the NASDAQ is up 1.75%. 

The disquieting market declines of the past few days were driven by a growing uncertainty concerning how much damage an expanding credit crunch could wreak on the global economy. While valuations and fundamentals remained quite attractive in many sectors and data continued to demonstrate solid economic health, fear took hold of many investors and some ran for the exits. No doubt much of the selling was from hedge funds unwinding leveraged positions and mutual funds meeting liquidation demands. 

Looking at historical earnings for the last 12 months stocks are unusually cheap. At the yesterday’s low, the average of companies in the S&P 500 was valued at 15.8 times earnings for the past 12 months, according to data compiled by Bloomberg. The ratio was the lowest since January 1991, when the index fell to 14.1 times profit. The price-earnings gauge last fell below 16 in May 1995, when the Internet bubble was beginning to inflate. By the time the S&P 500 peaked in March 2000, its value had almost tripled. 

Looking forward using analysts’ projections for earnings, stocks still look cheap, but not as much so because analysts have become rather pessimistic regarding future earnings. The S&P 500 closed yesterday at 14.8 times the average forecast, just above its average of 14.5 times for the past two years. A peak of 16.6 times was reached last month before the current crisis in credit markets, sparked by mortgage defaults, dragged down stocks.

Over the past five years companies have consistently beaten analysts’ projections for their earnings. According to Bloomberg data, second-quarter profits at S&P 500 members increased by 10.6%, more than double the 4.6% estimate when the period ended. The question we all ask today is whether theUSeconomy and indeed the global economy will grow sufficiently to support better-than-expected corporate earnings growth? The Fed boldly stepped up to do their part by opening the money spigots and promising to keep them open as long as is needed. If managers maintain a willingness to take business risks and the capital is there to fund them, then earnings growth will continue. We remain highly focused on the data and the trends it suggests.