Catch-22 at the Fed
Money and Markets
Martin here, with an urgent pre-Fed update.
It's Monday morning, just 24 hours before Ben Bernanke and the Fed meet to decide whether or not to raise interest rates for the eighteenth time.
Wall Street is on pins and needles. The whole world is watching. And perhaps more so than ever before in recent memory, no one at the Fed -- not even Bernanke himself -- seems to know what to do.
Reason: He's caught in a Catch-22 dilemma of unprecedented dimensions, squeezed from two sides.
On one side, Bernanke is squeezed by the slumping economy. Until just a few months ago, the economy still had momentum. Now, suddenly, housing is busting ... GDP growth has plunged ... new jobs are disappearing ... and unemployment is rearing its ugly head.
On the other side, Bernanke is plagued by surging inflation. You'd think 17 consecutive rate hikes would have been enough to nip the inflation in the bud. But the rate hikes were too slow, too little, and too darn late. Result: Even if you exclude rapidly surging energy and food costs, we now have the worst inflation in 11 years.
Here's the dilemma:
If Bernanke decides to raise rates tomorrow, it could break the back of the already-hobbled housing market and tip the economy into recession.
If he decides not to raise rates, it could be the last straw for the U.S. dollar, inviting out-of-control inflation.
All this is not exactly a good omen for stock investors.
Sure, the Dow Jones Industrial Average may be holding up. But major sectors are sinking.
Take the Dow Jones Transportation Average, for instance.
One hundred and twenty-two years ago, when Charles Dow first devised his averages, he focused on transportation companies -- the big railroads. They were the ones that dominated the stock market.
Indeed, back in those days, few industrial stocks were publicly traded, and even those few were considered highly speculative.
So contrary to what most people think, Dow's first index wasn't the industrial average. It was composed mostly of railroads, and he didn't create a separate industrial index until two years later.
Today, the Dow Jones Transportation Average includes not only railroads, but also major shipping companies and air freight carriers. But its importance is grossly underestimated ... and it's plunging.
The facts: Just three months ago, on May 10th, the Dow Transports reached an intraday high of 5,038.58.
But on Friday, they closed at 4,378.56, down 14.1%.
That's no small decline. If the Dow Jones Industrial Average had fallen at the same rate, it would now be trading at 10,175, or 1,065 points lower than its closing level on Friday.
Not convinced the Dow Transports are a big factor?
Fine. Then consider the Nasdaq. If any market has been at the forefront of investor attention in the last 10 years, it has been the tech-heavy Nasdaq.
The Nasdaq Composite Index reached this year's peak of 2,738 in April. Still a long way from its all-time high in 2000, but high enough to get lots of investors exuberant.
Now, it's back down to 2,085, off nearly 24% from this year's high.
Had the Dow Jones Industrials plunged that far from its peak, it would now be at 8,916. That's a whopping 2,325 points lower than the Dow closed on Friday.
Anyone who doubts the critical importance of these two markets need only look back at Charles Dow's original theories.
His view: All the major sectors of the economy are tied together. If one falters, it's a bad sign. If two falter, it's worse. And right now, you have at least two that are clearly running into serious trouble -- transportation and technology.
Indeed, these falling sectors are now being squeezed by the very same forces that are squeezing the Fed: They're impacted by a slowdown in consumer spending. They're getting caught by rising interest rates. They're getting slammed by the sky-high cost for energy and raw materials.
But if you think these averages are looking ugly, wait till you see the stocks that are caught in the crosshairs of investors looking to get out of the market while the getting's still good ...
Falling Like Flies
Just last Friday, the shares of Career Education Corp. (CECO) plunged a whopping 29.3%, and all it took to trigger the slide was one bad second-quarter report.
Excluding an $85 million impairment charge and including the cost for expensing stock options, the company still earned 36 cents per share.
Sure, that was a disappointment for analysts, given that they expected about 49 cents per share.
But for a stock to lose almost a third of its value in just one day is not a good sign for its industry ... or for the market as a whole.
Meanwhile, Friday's plunge in a leading biotech stock, Icagen Inc. (ICGN), makes CECO's plunge look like a joy ride by comparison.
Until May, Icagen was holding firmly between about $6 and $9 per share.
Now look! Friday, it closed at $1.12, down a whopping 73.6% in just one day of trading, and off nearly 90% from its high of the year.
Big Players Also
Getting Hit Hard
If this were happening strictly in less prominent companies, it would be of no big concern.
But some of the most widely-held companies are also feeling the pain. Just in the last three months ...
Ebay has plunged 25.2% ...
Legg Mason is off 26.1% ...
Harrah's Entertainment is also down 26.1% ...
Boston Scientific has fallen 27.2% ...
Qualcomm is off 32.6% ...
Corning is down 35.3%, and ...
Broadcom has plunged a shocking 42.4%!
We see stocks falling like flies not only in technology and transportation, but also in housing and construction ... employment and education ... gambling and entertainment.
More and more, the broad stock averages that are still holding up are giving you a misleading, distorted image of the real world.
Reason: A big portion of their apparent strength is due to oil, energy and natural resources.
Indeed, when you look at the Dow Industrials and the S&P 500, you might think the broad market is doing relatively well. Not true. Once you subtract oil and energy, you can see these broad averages are also slumping.
Still Fast Asleep
Despite the growing evidence, most investors still don't get it. They don't understand how you can have a slumping economy and surging inflation at the same time. But as we've been telling you for many months, you can. And, indeed, that's exactly what we're looking at right now.
Wall Street's response on Friday to the jobs report is a classic example.
When the news first came out that we had the worst unemployment rate in five months, investors actually rejoiced. They figured:
"Good. This means the Fed will have an excuse not to hike interest rates on Tuesday."
But by the end of the day, the reality began to sink in:
fewer jobs = sinking economy = sinking profits
That was the first disappointment.
Then, to add insult to injury, investors also woke up to the fact that, even while unemployment was up, wage inflation was also heating up!
That was the second disappointment.
The biggest disappointment of all, however, is bound to come in the weeks ahead:
Even if Fed Chairman loses his nerve on Tuesday and fails to raise interest rates, the markets will push interest rates higher on their own, with or without him.
Gold, silver and other metals will take off to the upside.
Oil and other commodities will roar.
The dollar will collapse.
Inflation will take off.
And in that kind of hot environment, bond investors will run for cover, driving bond prices sharply lower and interest rates sharply higher.
What to Do
Don't wait for millions of other investors to discover what you already know. By that time, they will have started to unload their shares in a big way, and it could be too late for you to get out of your vulnerable stocks at a still-decent price.
Instead, start to take action ahead of time: Sell stocks that are vulnerable to:
* Surging energy and commodity prices
* Higher borrowing costs
* A bust in the housing industry, and
* Slower consumer spending
Meanwhile, hold the stocks in sectors that stand to benefit the most from inflation: Mining, energy, and other natural resources.
Some investors say they can't sell because they don't want to take a loss.
I think that's baloney. If your stock is selling for less than what you paid for it, you already have a loss, and you can't turn back the clock.
Others investors say they can't sell because they don't want to take a profit ... and pay the taxes to Uncle Sam. That's also baloney. No matter when you sell, those taxes will be due. So it's irrelevant to your decision today.
My recommendation: If you believe things have turned sour -- or are about to do so -- the only rational approach to the market is to act on your belief. Period.
Suppose You Still
Want to Hold On?
Then, be sure to buy some "crash insurance" -- protection against stocks in your portfolio that may be vulnerable to either a slumping economy or surging inflation.
No, you can't buy crash insurance from your insurance company. Nor would I recommend it even if you could.
Buy you can easily buy a form of crash insurance through your stock broker, online or off. Here are some simple steps to follow ...
Step 1. Make a list of the worst stock market dogs you can find. These are the companies with the lousiest track records, the shakiest financial statements, the worst management.
How do you find them? They're everywhere -- in the news, in the latest list of worst performers for the day or among the stocks with the lowest Weiss ratings at www.WeissWatchdog.com.
Step 2. Check to see if there are options available on the worst dogs. Then look for options designated by a "p" -- for "put options."
Step 3. To better understand how put options work, consider this situation:
You own a home appraised at $250,000 and you need to sell it one year from today. But you're worried. Home prices are falling, and you can't afford to wait a whole year. If you do, you fear you might lose $25,000, $50,000, maybe even more.
So you go to your real estate agent and you say: "I need to lock in the current sale price, or something close to it."
Sure enough, for a fee, he can do that for you. He guarantees that, if he can't sell it at an acceptable price, you can "put it to him." In other words, he'll buy it himself at your price and eat any difference.
That's, in essence, a "put option" contract.
Or consider this example:
You own 100 shares of Microsoft, and it's selling for $25 per share. You're unwilling or unable to sell the shares, but you're worried that in the next six months or so, Microsoft could crash to $10.
So you go to your broker and you say: "I need to lock in the current price, or something close to it."
Sure enough, you can buy put options giving you the right (but not the obligation) to sell 100 shares of Microsoft for $24 per share. If the stock goes higher, you rip up the put option and throw it away. But if the stock plunges to $10, you can put the shares to the seller of the option, and he's going to have to buy your Microsoft shares for $24.
In this kind of a market, that's cheap insurance. It helps you lock in the current value of your shares. And it does not expose you to any risk beyond the modest cost of the options.
Step 4. With money you can afford to risk, consider going beyond protection and using put options as pure profit plays.
In this case, you don't own Microsoft shares. You just buy its put options to profit from its decline.
You buy the same ones as in the previous example -- giving you the right to sell 100 shares of Microsoft at $24 per share. And, as in the previous example, the shares fall to $10.
That's a great position to be in: That means you can buy the 100 shares of Microsoft for $10 each. Then, using your put options, you can turn right around and sell them for $24, giving you a profit of $14 per share.
Or, better yet, you don't have to touch a single share of Microsoft. All you have to do is sell the put option itself. The option may cost you no more than a couple of dollars per share. And in this example, it's probably worth close to $14 per share.
Indeed, with put options, your goal is no different than with any other kind of investment: Buy them low and sell them high. And when stocks crash and burn, it's not uncommon to see the value of their put options surge from, say, $1 or $2 per share to as much as $10, $15 or more.
Good luck and God bless!