A Quick Word on the Discount Rate and the “Ben Bernanke Grand Experiment”
(August 19, 2007)
Dear Subscribers and Readers,
Let us now begin our commentary by providing update on our three most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7, 2006 at 11,385;
2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;
3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.
As of Sunday evening on August 19th, we are still neutral in our DJIA Timing System (subscribers can review our historical signals at the following link). There is a reason why so many financial professionals get burned out – and the last ten trading days were a testament to that. The big news was Friday's surprised 50 basis point discount rate cut by the Federal Reserve – something which we had not anticipated (although this author had been discussing that the Fed Funds rate should be cut before this month is over) – but which is now very clear in retrospect. As subscribers may or may not know, the Federal Reserve's “Discount Window Lending Program” was revamped substantially during the middle of 2002 – whose purpose was to “improve the functioning of the discount window and the money market more generally.” Among its many changes, the amendment sought to:
- Increase the interest on “primary credit” (loans available at the discount rate to financially-sound institutions) to a rate about short-term market interest rates, including the Fed Funds rate – which historically has been approximately 50 basis points or so above the discount rate. The goal of the amendment was to increase the primary discount rate to a level approximately 100 basis points above the FOMC's then-prevailing target for the Fed Funds rate.
- Lessen the administrative burden on financial institutions to borrow from the discount window, by not requiring financial institutions to have exhausted other means of borrowing before turning to the Fed, and allowing credit-worthy institutions to borrow from the discount window with minimal paperwork.
In instituting the changes, the Federal Reserve's intention was first, to eliminate the incentive for financially-sound depository institutions to do a “carry trade” by borrowing from the discount window (at a discount to that of the Fed Funds rate), and in turn, lend the proceeds to the Fed Funds market. This “carry trade” was hugely discouraged (and rightly so) by the Fed and that is one reason why all financial institutions – prior to the 2002 amendment – had to jump through a lot of hurdles and red tape before they could get financing from the discount window. This also, in turn, had created a lot of disincentives for institutions to turn to the Fed in times of crisis, even though their needs may be legitimate. By increasing the discount rate to 100 basis points above the Fed Funds rate, the Fed – with one stroke – had destroyed any potential carry trade “arbitrage” between the discount window and the Fed Funds market. At the same time, this allowed the Federal Reserve to greatly eliminate most of the checks and balances before financial institutions can turn to the discount window – thus rendering the Federal Reserve a more effective financial mechanism for banks and other sound financial institutions during troubled times.
In the Fed's words: “A substantial spread would encourage depository institutions to borrow only to meet short-term, unforeseen needs. Too wide a spread, however, would mean that the federal reserve funds could, at times, rise to undesirably high levels about the FOMC's target … If, as is intended, the primary credit facility significantly reduces the reluctance of depository institutions to use the discount window, the Federal Reserve should be able to cap the federal funds rate near its target during a crisis by reducing the primary discount rate to a level close to the target.”
Subscribers who have the time and the inclination should read the Federal Reserve July 2002 bulletin for more clarification. For those who don't (and that means virtually all of our subscribers), this much is clear: The latest move by the Federal Reserve to lower the discount rate by 50 basis points was designed as a way to cap the Fed Funds rate – since the Fed Funds rate had been moving anywhere from 4% to over 6% in the last six trading days. The cut of the primary credit rate to 5.75% should now mean that the Fed Funds rate would never move above 5.75% - as folks who can't borrow from the Fed Funds market would now be able to borrow from the discount window itself, assuming that they have the necessary credit rating (if not, they can always get “secondary credit” from the discount window, at a rate of 50 basis points higher, or 6.25%). This would also mean that credit-worthy banks can borrow from the Fed at 5.75% and arbitrage at the Fed Funds market should the Fed Funds rate move above 5.75% at anytime. In essence, this latest move was merely designed to BOTH cap the Fed Funds rate and to cap the volatility of the Fed Funds rate – it does not mean that the Fed has really eased – it is merely making sure the financial system remains “orderly.” The Fed is trying to do as little as possible. Of course, at some point over the next few weeks, I believe the Fed will eventually ease – but most probably not until September 18th (a whole one month away) at the earliest, unless we see more disruptions in the financial markets in the coming weeks.
For those who have been looking for a “bailout” ala the “Greenspan Put,” they will not find it in the latest move by the Federal Reserve. It is important to note that Ben Bernanke is still trying to establish his own “footprint” on the Federal Reserve, and probably, more importantly, prove that he can be tough on inflation and to dispel his unfortunate (and unfounded) reputation as “Helicopter Ben.” I had previously discussed this in our October 27, 2005 commentary entitled “The Ben Bernanke Grand Experiment.” Even though that commentary is now nearly two years old, I believe that many points that I made in that commentary are still relevant – and I would highly recommend subscribers to go back and read that commentary, especially in light of recent events.
For those who want to read further on the Fed's course going forward, I would also highly recommend reading the book “Inflation Targeting: Lessons from the International Experience” which was co-written by Bernanke and several other authors in 1999. One is not qualified to be a “Fed Watcher” until one has read this book, along with Bernanke's work on the Great Depression. For those who do not have time to read “Inflation Targeting:, I will now highlight a couple of take-away points that I feel is essential from the book. Quoting Bernanke:
First, the increased emphasis on controlling inflation arises not because unemployment and related problems have become less urgent concerns, but because economists and policy-makers are considerably less confident today than they were thirty years ago that monetary policy can be used effectively to moderate short-run fluctuations in the economy, except perhaps fluctuations that are particularly severe or protracted. Further, most macroeconomists agree that, in the long-run, the inflation rate is the only macroeconomic variable that monetary policy can affect. When monetary policy-makers set a low rate of inflation as their primary long-run goal, to some significant extent they are simply accepting the reality of what monetary policy can and cannot do.
Thirty years ago, policy-makers and most economists supported “activist” monetary policies, which were defined as policies whose purpose was to keep output and unemployment close to their “full employment” levels at all times. Supporters of activism believed that there was a long-run tradeoff between inflation and unemployment, known as the Phillips curve. According to this view, the monetary authorities could maintain a permanently lower rate of unemployment by accepting some degree of inflation, and vice versa. At about the same time, large econometric models of the U.S. economy became available that promised to give policy-makers the quantitative information they needed to implement economic stabilization policies. To many economists and policy-makers, it seems possible that actively managed monetary (and fiscal) policies could be used to maintain maximum employment pretty much all the time. That happy outcome was not to be. The business cycle did not die a quiet death in the 1960s, as had been predicted by the more optimistic proponents of activist policies. Indeed, the recessions of 1973-74 and 1981-82 were the most severe of the postwar period. Nor did inflation vanish.
In conclusion, I believe that going forward, not only did the above make clear that the “Bernanke Fed” would adopt a policy that will be steered towards “inflation-targeting,” but given that the Fed does not believe in adopting an activist policy (targeting unemployment or GDP growth), the Bernanke Fed would be more reluctant to ease rates without a corresponding decline in the core CPI, unless the financial system itself comes “under attack.” While there is a good chance that the Fed Funds rate will also be cut in the days ahead, such a move will most probably not come until the next policy meeting (September 18th) at the earliest. Moreover – with the benefit of hindsight – it is now apparent that the Greenspan Fed lowered rates much more than they should in combating the deflationary effects of the technology bust 5 to 6 years ago, and given that global economic growth is still strong, there is now no reason to for the Fed to drastically ease rates (such as to 4% or below) going forward, unless 1) the core CPI decreases in the coming months, 2) leading indicators (such as the stock market, housing starts, unemployment initial claims, etc.) all start pointing toward a recession.
“Nothing is Obvious” Redux
In the “nothing is obvious” department, I noticed that many websites and blogs have noticed the record number of new lows achieved last Thursday – and why that this 1) constituted a severe oversold condition, and 2) meant that we are now bound to make new all-time highs in the major indices going forward. In doing so, they have often cited that on the three prior occasions that this has occurred (namely October 19-20, 1987, August 23, 1990, and August 31, 1998) over the past 20 years, the market has always gone on and rallied ahead in the days and weeks ahead, and as such, now is the time to go heavily long in the U.S. stock market. More specifically, the daily NYSE high-low differential ratio (number of new highs minus number of new lows on the NYSE divided by the total NYSE issues outstanding), hit a reading of negative 33.93% last Thursday – a level not seen since August 31, 1998, when it hit a reading of negative 32.71%.
Following is a chart showing the NYSE High-Low Differential Ratio from March 1965 to the present:
As can be seen on the above chart, there have been many instances since 1965 when an oversold reading such as what we got last Thursday resulted in more declines going forward. Obviously, the US$64 billion question now is: What is up ahead?
In the short-run, there is no doubt that the market was oversold on Thursday (and still is to some extent), and therefore, that the market should continue bounce higher over the next few days. In the longer-run, however, the picture is much more uncertain. First of all, while that has certainly been true in the last 20 years, it is to be noted that three occurrences over the last 20 years is hardly of statistical significance. Second of all – prior to the October 19, 1987 reading – there have been many more instances since 1965 when this reading had reached similar levels – only to see lower lows in the stock market going forward, sometimes by a wide margin. Moreover, during the times when such readings have resulted in lower markets, they have occurred very soon after the peak (such as late July 1969, or May 1973), similar to what is occurring today. In other words, as opposed to be a “bottoming indicator,” this latest “oversold reading” in the NYSE High-Low Differential Ratio is merely a reflection of significant downside breadth in the current markets – a picture which is not too surprising given the strong breadth (in all sectors, market cap segments, and in both growth and value stocks as well) we have witnessed in the stock market ever since the current cyclical bull market began in October 2002.
Following is a table showing the dates of historical sub (30%) readings in the NYSE High-Low Differential Ratio – along with subsequent 1, 3, 6, 9, and 12-month performances – from March 1, 1965 to the present:
I apologize for the “busyness” of the above table, but I believe the above table is the best way to present my observations. Firstly, I want to again emphasize that there has never been a case which has satisfied these two following conditions 1) a sub (30%) reading had occurred so soon after a major peak in the S&P 500 (in this instance, July 19th, or just four weeks after a major peak), and 2) a new high in the stock market soon afterwards, or even a year from now. The two closest scenarios where this has occurred is late June 1965, and late March 1980, when we got a sub (30%) reading in the NYSE High-Low Differential Ratio approximately six weeks after a major peak – and when the market went on to make new highs soon afterwards.
However, it is important to keep in mind that a year after the June 1965 readings, the S&P 500 was only 3% to 5% higher, while prior to the March 27, 1980 reading, the S&P 500 had basically only appreciated about 15% (not including dividends paid) in the last four years. Moreover, during the other instances where this has occurred soon after a major peak (such as June 1969, coming after the December 1968 peak, or March 1973, coming after the January 1973 peak), it had ushered in more selling going forward. While I am definitely not advocating that we are entering a new bear market, the above exercise is meant to alert our subscribers that last Thursday's “oversold reading” can be hugely misleading, as the historical record of this indicator is very questionable as a “bottoming indicator,” unless you narrow down your study period to the last 20 years (which is flawed).
Interestingly, if you substantially narrow your data points down by restricting this indicator to sub (50%) readings, the record is much more impressive. Indeed, aside from the October 19-20, 1987 readings, there were two other dates in the 42-year record of this indicator that satisfied this criterion, with those being August 29, 1966 and May 26, 1970. One month after these two dates, the S&P 500 had risen 2.4% and 6.0%, respectively. Three months later, the S&P 500 was up 7.9% and 17.2%, respectively. A full 12 months later, the rally has gone to 25.7% and 43.7%, respectively. A caveat to these readings, however, is that these readings came after a 21% and a 36% decline in the S&P 500 from their peaks, respectively. Sometimes, you want to be careful in what you wish for, especially when it comes to the stock market.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2005 to the present:
For the week ending August 17, 2007, the Dow Industrials declined by 160.46 points while the Dow Transports declined 193.75 points. In last weekend's commentary, I stated that given the weakish bounce (confirmed by the weak breadth) in the U.S. stock market of the week prior, chances are that there will be more downside ahead, especially in light of the fact that our technical/sentiment indicators have not reached severely oversold levels just yet. In this case, the market “cooperated” – as it continued to decline until at least late Thursday. However, as of late Thursday, the decline had definitely gotten ahead of itself – and as I have mentioned earlier, chances are that the market will continue to bounce over the upcoming week. Whether this latest rally will turn into something more sustainable, however, will depend on both the health of both market breadth and volume during any upcoming rally. For now, the jury is still out, but given that I do not believe the selling has reached “fever pitch” levels just yet, we will continue to remain neutral in our DJIA Timing System for now.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators again decreased significantly – from last week's 18.4% to 13.0% for the week ending August 17, 2007. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
Note that the four-week MA is now at its most oversold level since the week ending September 1, 2006. However, as I have mentioned in the last few commentaries, this author would like to see an oversold reading similar to what we experienced during the April 2005 (8.5%), the October 2005 (11.6%), and the June 2006 (1.7%) bottoms before we go long in our DJIA Timing System. For now, we are still not there yet – especially since a few of our other technical indicators (such as the NYSE ARMS Index, and the % deviation of the Dow Industrials from its 200 DMA) is still not at very oversold levels just yet. While these readings may come as early as sometime this week, this author is definitely more cautious – and therefore, there is a good chance that we won't go long in our DJIA Timing System until sometime after Labor Day Weekend – that is, until 1) hedge fund redemption starts drawing to a close, and 2) a few days before the due date for end-of-the-plan year contributions for calendar-year based defined benefits plan on September 17th.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:
Over the last week, the 20-day moving average of the ISE Sentiment declined substantially to from 117.1 to 103.5 points – the most oversold level since March 30th – after just hitting a 14-month high of 152.9 as recently as late July. While the freefall in the 20-day moving average is suggesting that retail sentiment has turned very bearish in the short-run (and therefore bullish from a contrarian standpoint), this author isn't going long just yet – as the 50-day moving average is still not close to being very oversold, and chances are that we will need at least a couple of more weeks to see an oversold reading in the 50-day moving average. Until or unless the 50-day moving average decline to a similar level we witnessed during recent bottoms (approximately 120), we will continue to avoid a long position our DJIA Timing System.
Conclusion: For readers who are avid “Fed Watchers,” please take note – as both the Fed's latest move and Chairman Bernanke's historical writings suggest that the Fed will be run differently compared to how it has been run during the Greenspan era. More importantly, Bernanke's latest action to lower the discount rate as opposed to both the Fed Funds and the discount rate suggests more of a reluctance to ease rates in order to stimulate economic growth – and a general reluctance to ease unless the financial markets freeze up or unless core CPI is definitely contained. Such a policy going forward is also rational from a historical standpoint, as 1) with the benefit of hindsight, it is now clear that Greenspan's “trigger-happy” policy of easing rates during the 2001 to 2002 bear market proved to be too loose of a policy, and 2) global economic growth, not including US economic growth, is now much stronger than it was during the 2001 to 2002 period, suggesting that not all of the “heavy lifting” has to be done by the US economy (interestingly, Chinese contribution to world economic growth should surpass that of the United States this year).
Finally, it is important to remember that it is probably still a safe bet to assume that there will be more market-moving bad news going forward – and even if not, there is a good chance that the next four weeks will remain tough in light of continued hedge fund deleveraging and the need to bring over $200 billion in both investment grade and junk bond financing as soon as there are first signs that the financing market has improved. In other words, there is still a huge overhang of supply over the next four weeks – and until we have worked that off – or until we get the long-awaited pension contributions on September 17th, chances are that we will retest the lows of last week. Over the next several weeks, I will most probably write more on long ideas in preparation for the inevitable rally. For now, we will just take it one day at a time, and be glad that we have not been caught in the latest downdraft.
Henry To, CFA