Fear and the Fed

Story Notes:

• The Fed cut key rates a big 75 basis points today, but markets still suffered a big drop.
• Market action remains classically characteristic of a bull market correction, not a bull market top.
• Recession fears today are overwrought given current conditions.
• A volatile market isn't confirmation of a coming recession—rather, it's confirmation markets are volatile.

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Markets took a tumble today in response to the Fed cutting key rates 75 basis points. If markets were demanding a big cut—and now—why all the doom and gloom? Some folks claim it's "too little" or "too late." Others say the big move is more evidence we're facing recession. But in our view, today's reaction is merely proof that first, Fed rate moves don't dictate market direction, and second, corrections are pure psychology—fueled by fears, not fundamentals.

This Wall Street Journal article has various economists' reactions to the Fed's move.

Economists React: ‘Not an Instant Fix'
By Phil Izzo, Wall Street Journal
https://blogs.wsj.com/economics/2008/01/22/economists-react-not-an-instant-fix/

Even with the Fed's new "transparency" and commitment to increased communication, reactions are all over the map. (For more, see "The Fed's Show and Tell," 01/14/2008.) We see nothing alarming in today's announcement—it merely shows the Fed can move nimbly when it needs/wants to.

So what is going on today? The market is correcting. Sounds simple, but feels dreadful. It feels like we've entered a new era where markets may never recover. That's how you know this is, in all likelihood, a correction and not a bear market. A bull market has a rolling, grinding top marked by investor euphoria; whereas a correction is a sharp, steep drop (or series of drops) marked by a huge, scary story. Today, the huge, scary story is the allegedly looming recession—but can you find any euphoria? Scratch that—can you find sentiment that isn't deeply, darkly dour?

Market activity today is classically characteristic of a bull market correction, not a bull market top. Bear in mind, we've not really had a normal correction this entire bull market—any pull-backs we've seen have been shallow or too short to qualify. In general, corrections can last three to six months. That the current correction, since October's peak, has lasted about three and a half months doesn't signify anything unusual.

What about recession fears? If we are entering a recession, markets could be pricing that in. Maybe—but there's a big difference between recession fears and actual recession. (Remember: Corrections are fueled by fear, not fundamentals.) Take a step back and critically consider headlines today. Is the magnitude of these fears warranted? Financials Q4 earnings were poor and probably will be this quarter too. Outside of that, earnings were largely healthy. And, for the full year 2007, Financials had the second best year on record. After a slowdown in Q1 2007, US GDP regularly beat expectations, and the world is expected to keep growing healthily in 2008. It would be very hard for the US, at about a third of global GDP, to head a markedly different direction from the rest of the world. Folks keep warning US GDP could "slow" but slowing is not recession. An economy can slow—even several times—and pick back up again healthily. There's nothing to fear from the US slowing modestly, particularly if the world keeps growing.

Another point almost no one mentions—long-term interest rates remain very benign. With so much focus on rising high-yield rates, no one notices it remains cheap for average companies to borrow. It's cheaper for above-average companies to borrow today than a year ago! The vast majority of America's largest companies can still easily borrow and have ample access to liquidity from a variety of sources.

Knowing everything you know about investing at the most basic and fundamental level, does now seem like the right time to sell? Is it ever a good idea to sell when the herd is panicking? Think about it another way—was it a good idea to buy and hold stocks when the world was nearly uniformly euphoric about the market in early 2000? About the worst time to sell is when everyone is clamoring that you should—and that's pretty much what we're seeing these days. And let's not forget market valuations. From a historic perspective, stocks look exceedingly cheap relative to bonds—and cheaper still today.

Folks point to recent market action as confirmation of their recession fears—but that's not right. The market's short-term action is simply confirmation of its own unique psychology. Recessions historically have not been widely predicted in advance, nor can we find any that resulted from people "talking themselves into recession." If a recession were to develop today, it would be the first that was long and widely expected—a very long shot proposition. While long shots are fun for the Super Bowl, when it comes to investing, they're never a safe bet—no matter how many people agree.

For more of our views on why recession fears are overwrought, see:

• "Market Noir," 01/10/2008
• "Terza Rima," 01/08/2008
• "Feel the Flow," 12/11/2007