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Being Street Smart 10/26/7


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#1 TTHQ Staff

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Posted 26 October 2007 - 03:01 PM

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BEING STREET SMART
___________________

Sy Harding

IT SURE HAS BEEN DIFFERENT THIS TIME. October 26, 2007.

The stock market of the late 1990s was led by the high tech sector, and a boom in internet stocks. When the tech sector imploded, led by the collapse of the internet stocks, the rest of the market followed, and the severe 2000-2002 bear market was underway.

The current bull market was led by the financial sector and a housing boom fueled by ‘creative’ financing. The financial sector has imploded, led by the collapse of the housing market. But the rest of the stock market has not followed. It has in fact moved on to record highs as recently as a few weeks ago.

Adding to the puzzlement, a seriously plunging housing sector by itself has almost always led to an economic recession. This one has not.

Similarly, high oil prices have always been a precursor to a recession. In this cycle we have had very high oil prices for more than two years, since oil popped above $50 a barrel in July, 2005. It’s at a new record above $91 a barrel now, almost twice as high as when it was considered to be high in 2005.

Other current conditions that in previous times also often led to serious market corrections include turmoil and uncertainty in financial markets, high levels of consumer debt, high levels of margin debt by investors, a slowing economy, to name a few.

In early 2001, as that economy was slowing, Yale professor Robert J. Shiller, who had correctly called the 1999 stock market top, authored a study on the causes of recessions. He wrote, “A recession is generally related to a decline in confidence, a decline that makes consumers less willing to spend, and businesses less willing to invest and hire more workers.” He referred to the Consumer Confidence Index, published by the Conference Board, as “a useful predictor of when consumer spending will drop”.

If so, that is yet another piece of troubling news. The Consumer Confidence Index, which was at 112 in July, fell to 105 in August, and 99.8 in September. On Friday, its rival, the University of Michigan’s Consumer Sentiment Index, fell to 80.9 in October, compared to 83.4 in September, indicating that confidence continues to decline in October.

So, this time around we have a veritable tsunami of troublesome conditions that have all swept in at the same time. And yet the stock market has shrugged them off.

Why is it so different this time?

A lot of the support comes from confidence that the Federal Reserve can rescue everything, including the economy, housing industry, and stock market by cutting interest rates a few times. That confidence received a big boost when the Fed did ride to the rescue when the market was seriously imploding in August, and its efforts worked. Well, it didn’t halt the slowdown in the economy, but it did give the stock market a boost.

But, it’s interesting to compare the situation to the last economic and interest rate cycle. The Fed began cutting interest rates on January 3, 2001 to try to prevent that slowing economy from continuing into recession. It didn’t work. It then cut interest rates 13 times in a row, but the economy slowed into the 2001 recession anyway. And after a positive response to the first rate cut, the stock market ignored the second and resumed its decline in the 2000-2002 bear market. The Fed Funds Rate was at 6.5% in 2000 at the stock market top, and at just 1.25% at the bear market bottom in late 2002.

Given the enthusiasm that’s back in the market this week on expectation the Fed will cut interest rates again next week, let’s look at the market’s short-term reaction to the first rate cuts in early 2001. The Dow jumped 300 points on January 3, 2001 the day the Fed made the first rate cut in that cycle. That’s pretty close to the Dow’s 335 point jump five weeks ago, on September 18, when the Fed made its first rate cut in this cycle.

In 2001, the Dow was then down over the next two weeks. But it rallied back in anticipation of a second rate cut late in January, about as been happening over the last week. However, with the second rate cut it began to decline, and was down 14.2% two months later (even though the Fed had cut rates two more times in the interim). The Nasdaq rallied for three weeks after the first rate cut, and then also began plunging with the second rate cut, and was down a big 37% two months later.

The jury is still out on how the market will react if the Fed cuts rates for the second time in this cycle, next Wednesday, as is widely expected. Faith in the power of the Fed riding to the rescue was sure not a good bet in the last cycle of a slowing economy.

But then, this time has been different so far.



Sy Harding is president of Asset Management Research Corp., publishes the Street Smart Report newsletter, and a free daily Internet blog at www.SyHardingblog.com. He also authored the 1999 book Riding The Bear – How To Prosper In the Coming Bear Market.