Tuesday, September 04, 2007

Does Bernanke Need Glasses?

- The news was good enough to close out the week with gain.
- Bernanke speech shows his eye is on the ball, but does he need some glasses?
- Inflation as measured by the PCE continues its positive trend.
- The game starts anew this week with higher volume and a load of economic data.

Stocks start strong and hold it to the close.

Bernanke was still warming up in the bullpen when the latest round of inflation data was released, the July PCE. It posted a second consecutive month at 1.9% year/year, within the Fed's comfort zone. Incomes came in at 0.5%, topping the 0.3% expected and pushing the year/year gains to 6.6%. That is not the crappy growth rate we are supposedly suffering through according to those on the campaign trail. Of course truth is typically the casualty of politics. In any event, even with Bernanke still to come investors appeared quite chipper as futures jumped sharply on the data.

There was another goose to the pre-market trade as the President's office announced President Bush would present a proposal to help alleviate some of the mortgage issues. The prospect of the executive office working in conjunction with the Fed had investors almost downright giddy. Futures were up in the 20 point range on NASDAQ and SP.

Of course, there is always the issue of whether a very strong open can hold, particularly when the market is still in a choppy mode, still trying to find its footing, and a major address by the Fed chairman is still to come. Indeed, stocks started to test immediately after the strong open. They were still positive but off their highs when the Bernanke text was released. The immediate reaction was lower, but it was not a dive downside, and after the market got over the fact that Bernanke was not ready to cut on Tuesday it rebounded. Didn't hurt that Chicago PMI was 53.8, topping expectations of 53.0.

The issue was still being decided when the President took to the microphone and put forth some of his ideas. He expressly said no bailout was planned, but that there were some things that could be done to help those stretched thin get through the tougher times and remain in their homes. He wants to extend FHA protection to roughly 80K mortgages, provide temporary tax abatement on taxes due when you refinance at a lower home cost, and better enforce predatory lending laws. Nothing all that spectacular, just something to show he was not as aloof as his father and that the government was doing more than just relying on the Fed and its interest rate stick.

The combination appeared to work. The indices double bottomed and rallied into lunch. A midday pause and then they rallied higher into the close, tailing off modestly in the last 10 minutes. The result was a solid gain for the session, but even with that the market closed mixed for the week, having to make a good comeback from the early week selling to do so. The Friday surge maintained their attempts at setting up some upside patterns off the bottom of this selling bout. It was no affirmation of a bottom in place, but it certainly showed that the hedge funds were not in selling once more to end the month as we feared would occur. With the Fed announcing it was in the game and the administration now wanting to gain some points with an "I feel your pain approach," that kept the sellers at bay, at least to end the month.

Technically the action was solid intraday. It gapped, tested, held on, and then rallied in the afternoon to close near session highs. Once more breadth was strong; it was strong on all of the sessions that showed a trend the past week and Friday was no exception with a 5.8:1 reading on NYSE. Volume was mixed but again low; Friday it was NYSE's day to show better trade, but still it was well below average.

That low volume is just right for forming bases, and after that hard selling that drove the indices lower to end July and start August, the low trade is consistent with base building: hard selling to start, then calming down on the bottom of the pattern. There is the negative connotation as well, the high volume dump, low volume recovery; that often ends with more selling before it is resolved.

The Friday action also left the indices at some prior highs in August or other key resistance such as the 50 day EMA where they stalled before. The low volume on the recovery to these levels leaves the move open to selling when everyone gets back into the market after Labor Day. That is the official start of September, and that is typically a tough one for stocks. As discussed Thursday, in 2006 it was no issue at all; in 2004 and 2005, however, there was some sizeable downside as the market worked on a bottom. Hmmm, seems somewhat familiar. For certain the increase in volume will mean the moves made are more meaningful.

The positive through all of this is the continued solid performance of market leaders such as AAPL, GRMN, BCSI, ZUMZ, NVDA, SLB, DO, etc. They are up but they are not trading on anemic volume when they make their solid moves. That is the backbone or the foundation of this market, whichever analogy you prefer. If they continue to hold their ground in the weeks ahead, that is a solid positive for the market.


Bernanke saying the right things.

The Fed chairman delivered what some styled the speech of his career. He did an admirable job of once again sticking to script and managing to please the market as well. As we felt he would, he reiterated the points in the Schumer letter, but there was more as well, an expression of a deeper understanding of the Fed's role.

Bernanke's speech can be broken down into four parts. First there was a discussion of the issues facing the market, a restatement of the Fed's recognition in its August discount rate cut that the danger to the economy held precedence over any inflation threat. Second, he reaffirmed the easing bias or at least the non-inflation bias. Third, he copied from the Schumer letter, saying the Fed stands ready to act if necessary. Fourth, the Fed stands ready to act, but he does not specify just how.

Some called it the Rorschach speech: you could see in it what you want. Indeed, when boiled down the 'action' part of the speech said that if the Fed felt it needed to act it would act. Now that is groundbreaking. In sum, just as the Schumer letter stated, the Fed stands ready to act if necessary.

There was a very important statement that showed the current Fed's views on when and why to cut rates. Bernanke stated it was not the Fed's job to rescue investors from poor investments. That has been the howl among many detractors with respect to any Fed action. He answered that with the most concise, salient response we have heard from a Fed member in decades:

"It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy."

"Well-functioning financial markets are essential for a prosperous economy. As the nation's central bank, the Federal Reserve seeks to promote general financial stability and to help to ensure that financial markets function in an orderly manner."

This is the kernel, the chewy nugget, the prize in the Cracker Jack box. The Fed is not there to rescue bad investments, but when those bad investments threaten the rest of the economy, it is the Fed's duty to step in and assure that the financial markets work as they should. Thank you. Clarity at last. Thus the Fed is watching how the financial markets are functioning. It saw they were showing signs of serious strain and stepped in with liquidity injections and then a discount rate cut. They were going to the heart of the matter, i.e. thawing the credit freeze with money, versus just cutting rates as a first step. Just as Bernanke cleaned up the Greenspan inflation hangover by lowering money supply that Greenspan allowed to expand even as he hiked rates, Bernanke is going to the heart of the credit problem by creating liquidity where there was none, thus allowing the financial markets to function and resolve the issues.

The irony of this is that many are hurling jibes at those of us who take the position the Fed should act, saying that we are crying for intervention when things go wrong while we say 'stay away' when things appear fine. That is a shallow view that misses the mark: when certain events disrupt the orderly function of markets the issues cannot be resolved on their own without threatening the broader economy. It is incumbent upon the Fed to grease the gears so the markets can trade and resolve the issues. That is all we want and that is what the Bernanke Fed is trying to accomplish versus slashing rates as the first visceral reaction to the credit issues. As somewhat of a proof as to the soundness of this plan, note how the markets calmed down once the Fed started injecting funds and then cut the discount rate. The bank to bank rates dropped and deals started to get done, i.e. loan packages started to change hands again. It is not fixed; a lot can still go wrong, but the Fed is doing its job by watching and stepping in as needed to help the markets function.

Inflation read gives Bernanke the room he needs.

The core PCE for July came in at 0.1%, down from a revised 0.2% reading in June, and matching the April and May reading. That kept the year/year core reading at 1.9% for the second month. Critics will quickly say it is just barely inside the Fed's 1% to 2% 'comfort zone,' implying it could take off higher next month if the Fed is not standing with its foot on the economy's throat.

But that view ignores what has transpired the past 23 months. Way back in early 2006 we wrote that it looked as if inflation pressures, not inflation, peaked in the fall 2005. The pressures were abating though actual inflation was still rising: squeeze a full tube and even after you let off it continues to squirt out until the pressure is worked off. Thus over the last 2 years inflation has peaked and then has started to fall. Once it started the fall, the drop from a 2.6% core reading less than a year back has been rather rapid. The trend is down; it is not about to ratchet back up out of control. This is the fallacy of putting so much faith in a number and not looking at trends and the underlying facts.

So what does this mean? It means inflation is not something the Fed should worry about, and this admission with the discount rate cut that it is no longer putting inflation first is a relief. We only hope it did not wait too long to make this change. Not from the inflation standpoint; we were not worried about that at all anymore. If you look at the past 6 months the annualized core PCE is 1.5%. For two years inflation pressures have fallen, and now inflation itself is falling MUCH FASTER. In another 6 months the annualized inflation rate will be at 1.5% or lower and the 6 month reading will likely be near 1%. Inflation? It doesn't just flair up in a month and thus run out of control. The pressures abated, it has started to trend lower, and it is starting to really fall over the past 6 months.

By: Jon Johnson, Editor

Jon Johnson is the Editor of The Daily at InvestmentHouse.com

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