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The 0.75% Federal Reserve Interest Rate Cut: A Recipe for Future Disaster

January 24, 2008-

At first glance, most investors might read the headline of this article with great confusion. After all, with a 600 point turnaround in the DJIA and significant rallies in Asian and European markets triggered by the cut, isn’t this exactly what the markets needed? My answer is definitively no, and let me explain why. Let’s take a look back at history to learn how the markets will behave going forward. On September 19th, I wrote a blog entry titled, “Why the U.S. Fed’s 0.50% Rate Cut Won’t Save the U.S. Markets”. In the article, I outlined several reasons why the 0.50% wouldn’t save the U.S. markets.

Back then, on September 19th, 2007, I stated:
“Alan Greenspan made this statement in 1966, 20 years before he would serve as Chairman of the U.S. Federal Reserve for almost two decades: “Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights”. One only need to understand the truth in that comment to understand where your money should be invested and why this mini-rally in global markets spurred by the Fed’s decision to cut the Federal Funds rate by 0.50%, even if it should extend into a larger rally, should cause you to be scared, and very scared at that.”

Today: What happened after I made that comment? The DJIA rallied to about 14,000 and then proceeded to plummet more than 1,700 points in a matter of weeks. The same problems that existed on September 19th, still exist today. That is an indisputable fact. Remember, just several months ago, U.S. Secretary of Treasury Hank Paulson urged Congress to raise the national debt ceiling, stating that the U.S. would reach the current national debt ceiling by October 1st. The decision to raise the ceiling from $8.965 trillion to $9.82 trillion, besides preventing the U.S. Government from defaulting on U.S. Treasury bonds, was necessary to retain international confidence in the “full faith and credit” of the U.S. government. This deficit hasn’t disappeared, and nor has the liquidity-soon-to-become-insolvency problems of banks, so there is no reason to believe that a more severe 0.75% rate cut is going to save the U.S. markets or prevent a continued global fallout at some point in the near future.

Even with a announced plan to bail out bond insurers, so what? Is that going to solve the dollar crisis and the bankruptcy problems of the U.S. government? In fact, taking into consideration the two 0.25% cuts in between, the Feds have cut the Fed Funds interest rate by 1.75% in just four months! These severe and rapid cuts should give you an idea of just how severe the underlying problems in the U.S. economy are. Furthermore, it generally takes a quarter or two for an economy to experience the real benefits of any rate cuts, so short-term, besides falsely restoring investor confidence, I don’t expect these cuts to save the U.S. markets nor the global markets. My same analysis back then holds even more true today. The 600 point turnaround in the DJIA on Wednesday, January 23rd should not be a reason for joy. If again, this mini-rally extends into a larger rally, then consider puts on the Dow. A greater day of reckoning surely awaits.

Back then, on September 19th, 2007, I stated:All the interest rate cuts in the world can’t solve the problems created by decades of poor risk management, loose credit, irresponsible money supply expansion and a stock market that has risen over the past year on the churning engines of debt expansion. That’s why when housing stocks continued to rise yesterday and were beneficiaries of the “a rising tide lifts all boats” theory, I established puts on some housing stocks. Any continuing rise in the share price of financial institutions with heavy exposure to subprime mortgages also offer fine opportunities to establish puts as well. The general investing public may be fooled by the interest rate cuts, but not me. I know that in the end, the house of cards will all come tumbling down.”

Today:
It’s a little bit redundant to state, but needless to say, after a brief rally in housing stocks, they continued their precipitous fall. Today, I still believe what I stated back then – that all the interest rate cuts in the world can’t solve the problems created by decades of poor risk management, loose credit, irresponsible money supply expansion and a stock market that has risen over the past year on the churning engines of debt expansion. With only 1 dissenting vote cast among the 9 member Board of Governors to cut the Fed Funds interest rate by 0.75%, apparently only William Poole seems to understand that by expediting the Dollar Crisis, they will create LARGER problems in the future. U.S. Secretary of Treasury Hank Paulson stated: “This is very constructive, and I think it shows this country and the rest of the world that our central bank is nimble and can move quickly in response to market conditions.” Perhaps constructive for a few days, or a few weeks, but then what?

The greater crisis at hand, much greater than the subprime debacle, is the Dollar Crisis. Slashing interest rates by 1.75% in four months may devalue the dollar enough against other world currencies as to convince foreign investors to temporarily keep their foreign capital invested in U.S. stock markets, but at some point, if the U.S. Federal Reserve insists on continuing to rapidly devalue the dollar to the point where global panic may ensue, then even the cheap value of U.S. markets will not be a strong enough incentive to keep foreigners invested in dollar-denominated stocks.

In addition, with a devaluing dollar causing raging inflation not only in the homeland but also in critical economic regions of the world like the Gulf Nations, a Dollar Crisis that is now building more steam (courtesy of the U.S. Feds) will have consequences far wider and far greater than the consequences of bad subprime debt.

So how should one play any subsequent rallies in the global stock market that are a consequence of the U.S. Fed’s 0.75% rate cut and possible subsequent rate cut next week? Eerily enough, history again, in the form of my November 16th , 2007 maalamalama newsletter, provides a solid lens from which to view today’s environment.

Back then, on November 16, 2007, I stated:


“The recent volatility in these global stock markets should be viewed entirely differently depending upon what markets you are considering. Here’s a quick guideline for the most likely behavior to pay off handsomely in the next year or so.

About U.S. Markets –

Use rallies like the one last Wednesday where the Dow piled on 300+ points in one session to sell out if for some reason you are still heavily invested in U.S. stocks. Even if the U.S. stock markets manage a sustained rally sometime within the next several months, it will only happen because the Feds aggressively slashed interest rates or the Working Group on Financial Markets is manipulating and massaging indicators behind the scene to allow this to happen. Any rally will not mean that the U.S. markets are on the way to recovery but merely that they are being set up for a greater fall. Of course, since most people psychologically feel comfortable behaving like barometers of the general consensus, and psychologically people fear taking an opposite stance from the rest of the crowd, they generally go with the flow to the detriment of their own portfolio performance.”

Today:

U.S. Markets —

Use sustained strong rallies in the Dow to consider buying put options on the Dow. This interest rate cut and any subsequent interest rate cuts are analogous to sending a 10-year old child to stick his finger in a levee that is about to burst. As long as the levee stays intact, a town can feel safe. But as soon as the kid tires, and removes his finger, all hell will break loose. I still fully expect triple-digit down days in the Dow to once again become commonplace in the future and for this bear market to resume its course.

Back then, on November 16, 2007, I stated:

About Precious Metal Markets –

“Use corrections, like this ongoing one, to add to positions at bargain basement prices. This is not a time to be fearful but a BUYING OPPORTUNITY. I said this in September when gold was at about $670 an ounce and now that gold has once again dipped below $800 again, this will be the last chance to purchase gold below $800 once this correction ends. Right now support exists at about $790 and gold should be supported by what I expect to be a dismal U.S. Treasury report Friday morning in the U.S. regarding foreign purchase of U.S. debt.”

Today:

About Precious Metal Markets —

Oddly the above statement holds exactly true today. Gold stocks have pulled back significantly during this global stock market panic, and today undeniably marks a buying opportunity once again. This is not to say that they might not head lower, but the odds heavily favor that in a few months, they will be much higher from their present share prices today. Of course, the price of gold now is much higher at about $890 an ounce versus $800 an ounce back then, but other than that, gold stocks are once again a great value, and likely to be one of the very few asset classes that will make people rich over the next five years.

Back then, on November 16, 2007, I stated:

About Foreign Markets with Economies heavily Tied to the U.S. –

“See the explanation for U.S. Markets above. Sell into rallies.”

Today:

My feelings on January 24, 2008, I still feel exactly the same. The only change is that, in addition, given strong enough rallies in the near future, I would also consider buying put options on the major indexes, and especially the Dow.

Back then, on November 16, 2007, I stated:

Foreign Markets with Economies with Little Dependence on the U.S. (i.e. BRIC, Brazil, Russia, India, China, etc.) –

“Buy into corrections, but be cautious as many emerging markets are heavily overbought now. Therefore, buy significant position only on heavy, significant corrections. Otherwise buy or add positions slowly over time.”

Today:

Some of these markets have had heavy, significant corrections but I would still exercise caution in these markets. The dollar crisis will affect these markets negatively as well. Furthermore, I would recategorize that statement as “Foreign Markets with Economies with Less (not Little) Dependence on the U.S. (i.e. BRIC, Brazil, Russia, India, China, etc.)”

I think it was a mistake back then to describe these markets as having little dependence on the U.S. economy. By mid, 2007, the Bank for International Settlements estimated that the OTC derivatives market had grown to a whopping $521 trillion, an incredible 41% growth rate over just the prior year. This $500+ trillion pound gorilla will ensure that all major and even large developing global markets remain inextricably linked to the world’s largest stock market for a while longer. In fact, today, I would further clarify my terse statement above by urging those that enter these markets to be extremely selective and to buy only stellar individual stocks, not country-specific mutual funds. There is still a lot of danger even in the BRIC markets. For example, over a year ago, on my investment blog, theUndergroundInvestor.com, I stated about the Chinese banking industry, “the sacrifice of strict risk management controls in pursuit of profits and spiraling growth makes a fine recipe for future disaster. Even though it took almost a year from the time I wrote about this topic for some of the problems of Chinese banks to bubble to the surface, they seem to be fully arriving now.” So be very particular about what specific industries you choose to invest in.

Finally….

Back then, on November 16, 2007, I stated:


Markets Tied to Commodities (i.e. Australia, Canada) –

“Use significant corrections to buy into markets.”

Today:

We’ve received the significant corrections that I spoke of above. It’s time to consider entering these markets. But in the end, despite consideration of other emerging markets, every portfolio, I believe, should be heavily overweighted in precious metal bullion and stocks.

[tags]dollar crisis, global economic recession, stock market crash, U.S. recession, federal reserve interest rate cut, commodities, gold, gold stocks[/tags]

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