Market History

Issue #1

February 2008

 

Big Ben and the Rate Cuts

Alan Greenspan’s predecessor Ben Bernacke has definitely had his job cut out for him the last six months.  He’s had to combat the worst housing depression possibly in history, react to the liquidity crisis that’s been taking place at all of the major financial institutions which has been spreading globally, keeping a watchful eye on inflation, and if that isn’t enough taking the necessary steps to ward off a possible U.S. recession to say the least Mr. B has been very busy.

The Federal Reserve has cut rates five times from 2007 through the end of February 08.  There are two rates the Fed has been cutting.  You’ve probably been hearing on the news that the Fed has cut rates again.  So what exactly does that mean?  Well basically there are two rates the Federal Reserve can reduce. 

1. Discount Rate-the rate the Federal Reserve charges banks for short-term loans
2. Fed Funds Rate-the rate which banks charge each other for overnight loans

	Year Ago	Current
Discount Rate	6.25%	2.50%
Federal Funds Rate	5.25%	2.25%

The first rate cut in 2007 came on August 24th, it was the first rate cut in four years.  Mr. B waited until the 11th hour, one hour before the option contracts expired, and then dropped the bomb of a surprise 50 basis point rate cut.  Why would Mr. B wait until one hour before the option contracts expire?  Because my friends Ben knows these markets, he knew the prior day 23.7M option contracts were exchanged (a record amount!).  Of those 23.7M contracts 57% were puts.  Puts are normally used to bet that the market will decline.  The Fed used the option traders to severely boost the market.  The tremendous amount of short covering that took place is known as the short squeeze.  When prices accelerate upwards it forces the shorts to cover and buy back the shares giving the market a hard bounce into positive territory.  It was a brilliant move on Ben’s behalf.

In the months to follow the Federal Reserve received much criticism for not reacting fast enough to the deteriorating credit markets and being behind the curve.  Investors were looking for more drastic action to be taken as a result of the liquidity crisis.  There was moderate inflation to consider but there should have been a little more aggressiveness displayed by the Fed when cutting rates.

On January 22nd the Fed cut rates by 75bps (.75%), it was the biggest one day move since the full point cut back in December of 1991!  This was the second surprise rate cut by the Fed.  The cut came after a global sell off on the 21st (which is Martin Luther King Jr. day and U.S. markets are consequently closed).  On the 22nd the Dow opened down more than 400 points (the low for the day was 11,508.24).  The following Wednesday there was an enormous 600 point swing in the Dow Jones.  During the Fed’s regularly scheduled meeting on January 30th rates were cut by another 50bps.  The results of the rate cuts were astounding!

DJIA Jan. 22nd Low	11,508.74
DJIA Feb. 1st Close	12,743.19
Point Increase	1,234.45
% Change from 1/22 low	10.73%

In a little less than two weeks the markets rallied 10.73%, kudos Mr. B, kudos.

 

Inflation

An important concept to grasp is the Feds ability to cut rates is determined by the rate of inflation.  Consumer prices rose at the fastest pace in 17 years in 2007.  Overall energy prices rose by 17.4% and food prices increased by 4.9% in 2007. 

	2006	2007
Increase in Consumer Prices	2.50%	4.10%

	Eggs	Milk	Bread (Whole Wheat)
Price Change Nov. 06′-07′	38%	30%	12%

However core inflation which doesn’t take into effect energy or food prices rose only 2.4% in 07 vs. 2.6% in 06.  High to moderate inflation limits the Federal Reserves ability to lower rates.  The major components of inflation are composed of unemployment, energy, and food costs.  Unemployment increased from 4.7 to 5.0 in December.  A healthy range for inflation is between 2-3%.

 

Real Estate Markets

A turnaround in the real estate markets isn’t expected until 2009-2010.  The rate cuts will help but will take time to get worked into the market.  In 2007 U.S. new home sales declined 26.4%.  The breakdown by region is listed below.

Northeast	Midwest	West	South
1.60%	-26.70%	-32.70%	-26.30%

 

Home inventory levels are at a 9.6 month supply.  I would expect this number to increase going forward.  Housing construction is at its lowest level since 1991 and building permits issued are at the lowest levels since 1993.  Foreclosures were up 68% in November 07 vs. same month year ago.  In the U.S. there was 1 foreclosure for every 617 households.  Home prices have had their biggest decline in 20 years.  The national median home prices dropped 5.8% in the 4th quarter (steepest decline ever).  The breakdown by region for the 4th quarter is indicated below.  The steepest decline was in Lansing, MI where the home values dropped a mind blowing 18.8%.

 

Northeast	Midwest	West	South
-4.80%	-3.20%	-8.70%	-5.40%

 

Home values are expected to drop another 10-15% in 2008, and possibly another 5% in 2009.  There are a few ways in which one could profit from the downturn in the real estate markets.

 

1. One way would be to setup an automatic investment plan (AIP) on a real estate mutual fund and have it run for the next couple of years.  That way you will potentially be able to have an average price per share at the lower end of the price range.
2. The second would be to look into Ultra Real Estate Proshares (ure), it’s an exchange traded fund that resembles twice the daily performance of the Dow Jones U.S. Real Estate Index. 
3. And last and probably the most time consuming would be to start buying real estate properties in distressed markets.  This may be the most profitable especially with all the short sales, numerous foreclosures, and low financing rates.  The lending environment has definitely tightened up (you probably won’t be able to finance 100% of the property value anymore) but for the aspiring landlord the timing couldn’t be better.

 

The World is Possibly Coming to an End

Recession, recession, recession, for those of you not living on the moon the last month this is all you’ve probably heard on the news.  We’re headed into a recession, we’re in a recession, and lastly we’ve been in a recession.  So what is the definition of a recession anyways?  A recession is two consecutive quarters of negative economic growth measured by the gross domestic product (GDP).  You’re probably thinking okay thats great but what is the gross domestic product composed of.  The GDP has five major components: 1) Consumer spending 2) Investment spending 3) Government expenditures 4) Exports 5) Productivity in distributing imports.  Consumer spending makes up 2/3rds of GDP.

As you can probably figure out we won’t know if we’re statistically in a recession until after we’ve already been in one for 3 months.  When the market declines we can experience one of two things, either a correction or a recession.

Recession: -20% loss in market value, 6-18 months

Correction: -10% loss in market value, 2-3 months

The Dow Jones has declined from a high of 14,279.96 on 11/11/07 to a low of 11,508.24 on 1/22/08.  The Dow Jones has already experienced a 19.4% decline in market value, which is an important statistic to keep in mind.

The bottom line here is the world is not coming to an end.  Recessions are part of healthy economic cycles.  If anything they create great buying opportunities.  There are a few positives that may prevent a recession or create a less severe one.  Global expansion, low unemployment, the weak dollar is making our goods cheap on a global scale and is consequently increasing our exports, and lastly stocks are priced lower than their historical average.