Bernanke Buying Spree: The Good, the Bad, & the Reality

March 19, 2009

By Andrew Mickey, Q1 Publishing

It’s the biggest, one-day economic shot in the arm the Fed has ever prescribed.

Just a few days after his PR tour on 60 Minutes , Fed Chairman Bernanke announced it is going to be pumping over $1.15 trillion worth of freshly printed dollars into the U.S. economy. The lender of last resort said it will be buying mortgage-backed securities from Fannie Mae and Freddie Mac debt and loaning throwing another $100 billion into the Freddie and Fannie black hole.

The big move though, and what got the markets rolling again, was when the Fed said it will be buying “longer-term” treasuries. This basically means the U.S. government can now borrow money directly from the Fed. It doesn’t have to worry about China or Japan financing a massive debt load and can disregard any sort of fiscal discipline. The Fed is now the official sugar daddy.

How will the Fed get all that money, you ask?

Well, it can’t tax people. And it can’t take it from the banks. So it creates all that money out of thin air.

As you might expect, gold soared 7%, the U.S. dollar fell almost 5%, and the yield on treasury bonds went even lower.

As with all government interventions, we should expect the unintended consequences to be just as big, if not bigger, than the initial action. In a way, economics works just like physics. So now is the time to get prepared for the “equal and opposite reaction” from the Fed’s latest move.

There will be a way to profit from the good (which the short-term traders focus on), the bad, and the reality (what we’ll focus on) of this massive move by the Fed. Big changes are coming and it’s still not too late to ensure we’re a few steps ahead.

The Good

The good side of this gamble (the very limited good side) will be seen in the housing market. The intended consequence of this Fed action is to push mortgage and lending rates lower.

Since the Fed buy’s long-term debt and increases money supply, there will be a lot more to lend. More dollars chasing the same amount of loans pushes the return (interest rates) on those down. Mortgage rates are on their way to 4% which will help keep the value of houses up, prompt more homeowners to refinance, and push the overall cost (the monthly payments at least) of buying a house down.

We’ve already watched the positive reaction in housing stocks and the overall stock market. Yesterday’s announcement set the bulls back in motion. Homebuilder stocks climbed an average of 15% across the board and the overall market continued to rally.

It was great news all around, until everyone realized the bad side of it all.

The Bad

This is where it gets ugly. The last time the Fed bought long-term treasuries to push long-term interest rates down was in the 60’s. The following decade was filled with economy-destroying levels of inflation.

Will history repeat? There’s certainly a very good shot.

That’s not all of the bad news though. Another negative consequence will be the value of the U.S. dollar.

If you recall a recent talk we had with John Embry of Sprott Asset Management, one of the world’s most noted and knowledgeable gold investors, he told us what was about to happen. Embry said, “Eventually, you reach a certain point where you can’t really add any more debt because the capacity for the system to handle it has been exhausted. Once it reverses, it’s very hard to change. They are going to try to change it by simply debasing the money.”

When you consider gold rose 7% and the U.S. Dollar Index fell almost 5%, it’s easy to see what the market thinks these moves and future moves like them will have on the value of the dollar.

Now, there is a good and bad side to the dollar falling. On the good side, it will make our exports cheaper. On the bad side, we won’t be able to buy nearly as much stuff from foreign countries. It’s a win/lose situation which is never good, especially if other countries jump in to devalue their currencies (Switzerland, Russia, etc.).

The Reality

I realize we’ve been bearish on the markets for months now. Every rally which has come along we’ve raised the “B***S***” flag and picked out what the market was missing.

I’ve got to warn you, it’s very easy to fall into the trap of being consistently bearish and missing the best buying opportunity of our lifetime. That’s why we’ve spent a lot of time over the past week trying to pick apart our rationale and constantly ask “What if I’m wrong? If so, where?”

Frankly, constantly challenging your thesis is the only way to ensure you hold on long enough for the big payday that comes with being right. That’s why I’m not too worried about missing this rally. Its end will come and I bet it will be soon – probably by the summer. Here’s why.

The mountain of problems the economy is still facing has not been dealt with.

Just take a look at today’s news from the auto industry. The auto parts suppliers are getting a $5 billion cash infusion courtesy of the U.S. Treasury.

Great! By not dealing with the automakers in an effective or timely manner, now the parts suppliers want their bailout…what’s next? We have to bailout the steelmakers. After all, they make the steel for the auto parts for cars that nobody wants.

Seriously, where does it end?

I doubt anytime soon. Don’t forget, the government is set to release its plan to “fix” Detroit’s problems in the next few weeks.

Of course, that’s just the start of it. And all that is all known and expected. To be successful, we have to focus on what the market doesn’t know or hasn’t anticipated yet. We’ve got to focus on (as you’ll here many pundits put it, and I cringe as I do it as well) next shoe to drop.

Well, no one was talking about it until Meredith Whitney, made an appearance on the Charlie Rose show.

Whitney, who really made her mark by rightfully putting the “Sell” recommendation on Citigroup back in 2007, laid it all out pretty simply, “If the rules are constantly changing, you’re going to have a freeze in commerce. You’re going to have a freeze in spending…and people are going to be too scared to act. A lot of companies have already behaved that way. They’re too scared to act because the rules are changing on them constantly.”

She goes on to point out, “The math [shows] the worst is ahead of us…you continue to have credit pulled from the system and until it stabilizes, you have nowhere to go but down.”

There are still mountains of issues to be worked out for credit card debt, commercial real estate debt, commercial mortgage-backed securities, pension funding gaps, and unsustainable state budget deficits.

Bull Market in Uncertainty Continues

Think about it for a moment from a manager’s perspective. You have to allocate capital. You have to decide what to invest in, where to focus your efforts, gauge demand, and plan accordingly to be successful.

You can’t do that if the rules keep changing. Just look at the solar industry as an example. Solar companies make and sell panels to consumers, primarily utilities and retailers. But the consumers can’t make reasonable purchase decisions until the rules are set.

Will we get a cap-and-trade carbon system? How big will the tax subsidies be for solar panels? Will utilities be able to raise rates in order to fund a less efficient electricity generation system? There are just too many unknowns for business managers to make moves.

The same is true for managers across all industries as the tax code is being rewritten. There are plenty of rules to change ahead and, as a result, managers in oil, utilities, banks, private capital funds, and every other industry won’t be able to make the right decisions until the rules are set.

We’ve talked about the “Bull Market in Uncertainty” before, and now we’re seeing the impact. The economy will not be able to get going again until many of the uncertainties are eliminated.

That, I’m afraid, is months and months away and the current rally has all the makings for nothing more than a bear market bounce.

As far as I can see, the market still hasn’t fully anticipated the decimation to insurance companies’ balance sheets, what 10% unemployment will do to corporate earnings, and how long it will take for confidence to return to businesses and consumers.

Good investing,

Andrew Mickey
Chief Investment Strategy, Q1 Publishing