Wednesday, February 27, 2008

Equity Market Insight for Wednesday

Good afternoon. The equity market continues to struggle as we predicted. Bernanke said nothing new as far as we're concerned at the Psychology of the Call. No doubt the Fed is facing treacherous waters as they try to steer their large vessel of Fed funds. Just what some equity traders fail to understand is that the Fed has absolutely no control over where long term interest rates go, and these are the rates that really matter for analyzing stocks. Even though the equity risk premium is overwhelmingly on the side of stocks at present, the markets fail to rally through certain resistance barriers. This is not good for bulls. The Fed funds rate is simply a rate that Banks charge each other for overnight transactions, nothing more. Still, the Fed funds rate is like the Sun in our Solar system; without it there would be no life and therefore no expansion of credit. Expansion of credit is what eventually creates jobs, increases corporate profits and hopefully stock prices. Stock prices rise and fall based on what investors are willing to pay for a given Dollar of earnings at a given time, or the P/E ratio. P/E ratio's contract or expand with investor sentiment/psychology. Furthermore, many equity investors fail to understand that the credit markets are just one factor that build or destroy P/E ratios. Bonds are a safer asset class to begin with, so why would a seasoned pro buy stocks when the credit/bond markets are suspect? In a free market system supply and demand forces should have free rein. Nonetheless the Fed's ability to control the Fed funds rate is where it begins and stops for them. The Fed is not as powerful as perceived; credit market "sentiment and psychology" plays a much greater role, since long term interest rates are set by supply and demand forces, regardless of what the Fed does with their overnight Fed fund transaction fee. The Fed can make over night loans cheaper and cheaper for its member Banks; they can lower rates to Greenspan levels of 1.25%, or even zero as my friend and retired executive Lance commented, but that doesn't mean people will want loans, or that Banks will be willing to offer the loans on favorable terms. The foundational crack in the Real Estate mortgage market is something that will take time to correct; "hang over" (inventory) is still a factor we must work through, regardless of what the cost of money may be. One negative thing for the equity market was Bernanke's tone of voice. His voice trembled and his delivery sounded uneasy and unsure, even when reading his prepared remarks. We caution equity investors not to commit more than 50% of their capital until the S&P breaks through 1475 on the upside, or retests 1270 on the down side. We suspect that 1270 could be tested when the Employment numbers are posted on March 7. With that date in mind, we appreciate your attention, and as always, the Psychology of the Call matters.

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