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Generational Dynamics Web Log for 12-Dec-07
Investors suddenly end orgy after "miserly" Fed interest rate cut

Web Log - December, 2007

Investors suddenly end orgy after "miserly" Fed interest rate cut

The Dow Industrials feel 270 points in 30 minutes on Tuesday, and then and then fell 70 more points before the final bell.

Dow Industrials fell sharply at 2:15 pm on December 11, after Fed announced a Ľ% rate cut.

Dow Industrials fell sharply at 2:15 pm on December 11, after Fed announced a Ľ% rate cut.

The sharp tumble began at 2:15 pm, when the Fed announced a Ľ% rate cut to 4.25%. Investors had been hopin' and prayin' for a "surprise" ˝% rate cut, and expressed contemptuous attitudes at the Ľ% announcement, with one economist summarizing it as "Wimps vote for mush."

Another economist called it "the biggest flop since Ishtar," and a Bear Stearns statement called it a "miserly action."

Now, as I've said many times, Generational Dynamics is less concerned about the daily ups and downs of the stock market, and much more concerned about the attitudes of large masses of people, entire generations of people. The ups and downs of the stock market are of interest only insofar as they reflect the attitudes of large masses of people.

So the fact that this contemptuous attitude toward the Fed rate cut is so widespread is worth examining closely.

Dow Industrials surged after two "surprise" rate cuts (Aug 17 and Sep 18), but fell after two "ordinary" rate cuts (Oct 31 and Dec 11)

Dow Industrials surged after two "surprise" rate cuts (Aug 17 and Sep 18), but fell after two "ordinary" rate cuts (Oct 31 and Dec 11)

This graph shows the results of the last four Fed rate cuts:

The Aug 17 Fed cut in the discount rate was unscheduled and so was a complete surprise; the Sept 18 rate cut of ˝% was a surprise, much higher than the expected Ľ% cut. The market surged after each of these rate cuts.

The Oct 31 and Dec 11 rate cuts of Ľ% were as expected. On both occasions, the market surged in the days prior to the announcement, as investors became erotically aroused at the thought of a new "surprise" -- an unexpected ˝% rate cut. When the investors became frustrated, not only did the market not surge either time, but in fact the market fell sharply on both occasions.

In addition, the credit markets responded negatively last week when the Bank of England lowered its Bank Rate Ľ%. In fact, the Libor interest rate (sterling, 3 month) spread continues to increase every day. As of Tuesday morning, the Libor was at 6.63%, representing a "spread" of 1.13% above the official BoE Bank rate of 5.50%. This continual increase is very ominous.

And so we reach the following conclusion: The only thing that will push the market up is the ANTICIPATION of a much larger than expected Fed interest rate cut.

Now let's take a look at something interesting:

Probability of various outcomes of Fed Funds rate at Tuesday's Fed meeting, as determined by investor "bets."

Probability of various outcomes of Fed Funds rate at Tuesday's Fed meeting, as determined by investor "bets."

The explanation of this chart is as follows: Since the Fed Funds rate was 4.50%, the possible outcomes of Tuesday's Fed meeting was they would leave it unchanged at 4.50%, raise it to 4.75%, or lower it to 4.25%, 4.00% or 3.75%.

The above chart, is provided by the Cleveland Fed, is based on data provided by the Chicago Board of Trade (CBOT).

The CBOT allows you to bet on one of the possible outcomes, by purchasing a a "binary option" on any desired target rate. If you select the correct rate (4.50% in this case), then you get $1,000; if you select a different rate, then you get nothing.

Based on the investor "bets," the CBOT can come up with an estimated probability of investor expectation of the outcome of the Fed meeting.

The chart above represents "bets" as of the end of last week. Reading values off the graph, you can see that the expected probability of each outcome was as follows:

    Target Fed        Probability of
    Funds Rate          that outcome
    -----------       --------------
    3.75%               0.01
    4.00%               0.28
    4.25%               0.70
    4.50%               0.00
    4.75%               0.01
    -----------       --------------
    TOTAL               1.00

As you can see, the probability of a 4.25% outcome was the highest -- at 0.7 (or 70% probability) -- and that was the outcome that occurred on Tuesday. However, the probability of a ˝% decrease to 4.00% had risen to 0.28 (or 28% probability), meaning that more than a quarter of those making "bets" thought that there would be a "surprise" ˝% rate cut.

Now, look at the "4.00%" across the graph. It's at probability 0.0 on November 2, remains around .01 until November 27, and then suddenly jumps to 4.00%.

What happened on November 27?

We're now able to correlate three different things that happened around November 27:

As I wrote in a Nov 27 article, international credit markets were nearing "virtual panic mode," as interest spreads continued to increase.

The probability of a ˝% Fed interest rate cut went from 0.1 to 0.3, in the expectations of investors who "bet" on the CBOT options described above.

The Dow Industrials began to surge from 12743 up to Monday's peak of 13727, in anticipation of a Fed "surprise" interest rate cut of ˝%. When the actual cut was Ľ% on Tuesday, the index fell to 13432.

So when you put this all together, you can see how absolutely crazy this is. The news about the international credit markets was INCREDIBLY BAD. But investors treated it as good news, because it was so bad that it would cause the Fed to cut ˝%.

This is the crazy "bad news is good news" syndrome that we've been seeing for the past couple of years, and it appears to be getting worse. Investors talk about things like earnings and valuation of the stock they buy, but the only thing they care about is what the Fed is going to do. There is no rational connection between stock market prices and anything going on in the world.

Even the normally bubbly commentators on CNBC are beginning to notice this. It's frequently said that the market didn't pay much attention to the August credit crunch, even though if there were anything rational going on, stock prices would have fallen and stayed down on the news.

In fact, this is the point that Bank of England governor Mervyn King made last month when he predicted a severe fall in stock prices:

"It is very striking that despite the developments we've seen in the last three months , despite the stresses and strains in the banking sector, equity prices are higher now than they were in August."

That was a month ago, and the situation has gotten much worse since then, especially as banks hoard money and lending rates surge.

A particularly notable event occurred on Monday, when Europe's largest bank, UBS AG, announced that it will be forced to write down $10 billion in its asset pool, after already writing down $4.66 billion in the third quarter. The reason is that the pool contains CDOs backed by "subprime" mortgages.

We're talking about real money here when we talk about these huge losses. UBS might be on the road to bankruptcy, but they've been saved by an $11.5 billion investment from the Government of Singapore Investment Corp., in return for which Singapore will own 10% of UBS. UBS raised another $2 billion from an unnamed Middle Eastern country. This deal resembles the deal struck by Citibank, which was saved by an investment by the Abu Dhabi Investment Authority, after it took $16.4 billion in writeoffs of worthless CDOs.

From the point of view of Generational Dynamics, we're overdue for a new generational stock market panic and crash, followed by a 1930s style Great Depression. The scenario that's going on today, with CDO writedowns, "surprise" Fed announcements, and daily bank writedown announcements, could not have been predicted in 2002, when I first predicted a coming stock market crash, based on the fact that stock market is overpriced by a factor of around 250%. (12-Dec-07) Permanent Link
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Generational Dynamics Web Log for 12-Dec-07 Investors suddenly end orgy after "miserly" Fed interest rate cut

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Generational Dynamics Web Log for 12-Dec-07
Investors suddenly end orgy after "miserly" Fed interest rate cut