Believe in the Market Not the Fed
September will be an interesting month to say the least. The macro economic and interest rate environment is going to change. The Fed is going to start a cycle of lowering interest rates. Will lower rates fix the subprime mess and make the market go higher or will the market enter a bear market anyway?
In 1998 the potential collapse of Long Term Capital Management sent the market lower and when the Fed helped bail it out by lowering interest rates they created so much extra money in the economy that it had it no where to go. There were not enough real investments in the economy so it went into the phantom Internet stocks, creating a bubble in the Nasdaq in the process.
When that bubble collapsed the Fed began to lower interest rates in January of 2001 and the market dropped anyway as the Fed lowered quarter after quarter. It took a year and a half for the market to bottom, even though everyone thought it should go up when the Fed first started to lower rates.
Fed rates cuts don't always make the market go up. In the 1970's there were several instances when the Fed lowered rates and the market went down anyway. And of course that's what happened in 1929 too.
What matters when the Fed lowers rates is how the economy responds. If the economy goes into a recession despite the lower rates than the stock market drops, but if the economy strengthens the stock market goes up.
What happens over the next six months or year with the stock market depends on whether or not the woes in the real estate market spill over in the real economy, thereby causing a recession and taking the stock market down with it despite the Fed lowering interest rates. And of course the market will fall ahead of the economic weakness if that happens.
If real estate and the stupid loans banks make and hedge funds bought during the boom is going to continue to be a growing problem then the market will fall after the Fed lowers interest rates at its September 18th meeting, take out the lows of August, and wipeout. If the Fed is going to fix the subprime problems then the market will stabilize over the next six weeks and go higher into the end of the year.
It's that simple folks.
The problem is it isn't at all clear which is going to happen. The truth is the reason why there are problems in the credit markets are because the banks don't trust each other!
Yesterday the costs of borrowing money in a three-month time frame hit a ten year high in England. The interbank rate for three-month sterling hit 6.74 yesterday. According to the Times of London:
"Barclays disclosed that it was paying the highest rate of all banks for three-month money, estimating that it would cost the bank 6.8 per cent - more than the Bank of England's 6.75 per cent penalty rate - to borrow sterling. That failed to dampen the bank's share price, which leapt almost 4 per cent to close at 638p yesterday after Bob Diamond, the chief executive of Barclays Capital, reassured the market that the bank had not made significant losses in the recent market turmoil."
Despite the Fed lowering the discount rate and pumping billions of dollars into the money supply on almost a daily basis it is clear that the credit turmoil is not over yet. Will it end this month or become a growing problem is an unknown. There is no way for us to know what is on the balance sheet of secretive banks and hedge funds. They are the masters of our economy and we are supposed to do what we always do. Trust them. That is what the Fed is for.
Believe in the wizard behind the door.
Of course blind faith in the Fed cost lots of true believers and gullabulls money in the last bear market. We were told that when the Fed cuts rates the market always go up. Of course history showed that this was usually true, but not always. But those exceptions were ignored, because most investors were conditioned to believe that the Fed will always make the market go up. That was what they did in 1998.
The next six weeks will tell us whether or not the Fed succeeds again this time.
Of course we won't just sit there and hope. As the next few weeks evolve the market will give us clues and tell us how to position ourselves. Will gold come back to life this month and make new bull run into the end of the year? Will some other sectors come alive and enter a bull market? Usually that's what happens when you go through a correction and period of consolidation that lasts four to six weeks. And when it does that's where the big money is to me made. Or will money have to be made on the short-side? All of these questions will be answered and in the end there will be a great buying opportunity.
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