Thursday, November 29, 2007

Searching For The Magic Formula

To some, the powerful two-day stock market rally was all about the prospects of the Fed cutting rates. While this no doubt was a contributing factor, the larger issue that may have been lost in the noise of rate cuts is the attempt by the Fed and other interested parties to secure the core of the financial system (i.e. big banks). Those at the periphery of the system can break down (hedgies, private equity, mortgage bankers and brokers, even investment banks), provided their problems do not metastasize inward toward the core of the system.

What seems to also be lost in all the noise re rate cuts and traditional real economy stuff is the concurrent effort of the Fed and other interested parties in fixing what got broke. Specifically, the financial model that gave us the Great Moderation (lower rates, low inflation) and all the wonderful real economy benefits complements of Globalization.

Perhaps it is the street kid in me but I find it rather curious that earlier this week the Fed pumped $8 billion into the system followed by ADIA (Abu Dhabi Investment Authority) pumping $7.5 billion into Citigroup (a core of the system entity) at the same time Fed Vice Chairman Kohn gives a speech widely interpreted as communicating the Fed’s intention to do whatever it takes to maintain the monetary boat. Random events? Reactionary decision-making? Maybe not.

In my view, what is happening is an attempt by the Fed and other interested parties to find that magic formula that can both secure the core of the system and invent a new and improved financial model, one that will enable the Great Moderation to live another day.

The core of the system cannot break down. The Fed has stated as such many times over (read just about any speech by Bernanke and other important Fed heads and you will hear this theme stated explicitly or implicitly). Now, this is not to say too big to fail is part of the policy solution currently being orchestrated the Fed and other interested parties with its attendant moral hazard implications. However, failure in the core of the system has very different meaning as in a managed transition to another entity that can ensure the system functions effectively. Think ADIA and Citigroup.

Investment Strategy Implications

The big equity markets' hurrah of the previous two days was about more than a simple rate cut. It was about the perception that the Fed and other interested parties seem to be making progress toward reestablishing a secure core of the financial system and reinventing the magic formula of economic peace and stability to the system, the markets, and the real economy.

To be sure, more pain is headed the markets way. Yet, unless one believes that the mark-to-market pain will aid and abet a US recession, which will precipitate a global slowdown or worse, which will thereby produce a double-digit decline in corporate earnings (see the Expected Return Valuation Model in my reports*) while at the same time the Fed and other interested parties are too dumb and lack the innovative wherewithal to work their way out of this mess, the credit derivatives problems of yesterday and today are fast becoming old news. And old news does not move markets. New news does. And the new news is the progress made toward reinventing the magic formula.

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