The Fed’s Magic Words

Investors await the magic economy-healing words of the Fed, due to be bestowed on us at 2:15 this afternoon. Seriously though, I really don’t get why the financial media continues to ponder the question of how Bernanke can fix the economy. He can’t. Monetary policy can’t lower debt.

Sure, low interest rates can create an environment where debt can be refinanced on more acceptable terms. Low interest rates also make investment cheaper. But if demand is slack due to debt (and unemployment), the Fed is not the one to fix it.

And really, while any talk of fixing the economy has to start with fiscal policy. But even then, there are limitations to what any local, state or federal government can do. Time is the great equalizer. As a nation we over-borrowed against future production. And it’s really only that future production that can reduce the imbalances in the economy.

The market seems to be expecting Bernanke to do something. Perhaps he will announce the "twist" selling out of short-term Treasuries and buying the long ones.

It seems really unlikely that the Fed can expand its balance sheet. So re-arranging the deck chairs may be the only way to appear to do something, without really doing anything.

It’s hard to see how investors will not up disappointed by the Fed’s statement today.

TradeMaster’s Jason Cimpl notes that the Fed has targeted long-term yields before:

The U.S. has actually used this strategy before. But that was back during the Kennedy administration. Although it’s been awhile, the last time the Fed used a strategy similar to "Operation Twist" the result was that the policy had a meaningful impact on yield.

Investors have lost confidence in the economy, and rightfully so. But the market could become much worse if traders start to think Ben Bernanke will not provide aide. While I don’t think another round of easing is good for the long term economic health of the nation, if Ben Bernanke sits idle now – the market will fall.

Jason’s been on a pretty good run lately, 8 of his last 11 trades were winners, including a nice 11.6% gain on Apple as it broke to new highs above $400.

The last time Jason was wrong about the market’s direction was July 14, 2009. I’m not kidding. Intel reported that day, and Jason thought it meant a bearish turn was at hand. You may recall, the market’s had been rallying strongly after the March 9 lows. And they didn’t turn after Intel. It’s tough to blame Jason for being bearish at the time. There was still a lot of uncertainty in the air.

I’ve never seen an analyst be more consistently right about the stock market than Jason Cimpl. You can give his service, TradeMaster Daily Stock Alerts, a 30-day trial HERE.

Dave wants to know if he should sell out of his 401K:

Quick question, with all the crazy swings in the market, should I lock in my 401K into a fixed account till the markets gets better? If we have a major crash I don’t want to have zero or close to it left.

These are tough question. Get it right, and you’re a genius. Get it wrong and you’ve cut your portfolio’s earning power.

I have a question. How often does the stock market have a major crash? It’s not that often. Crashes almost never occur from events that we can anticipate. And I suspect that you can argue that crashes mainly occur during bubbles, when leverage is high.

Now, Greece and the European debt problem is a potentially significant event that could knock the stock market back. There may be some positioning changes that could help. And I have a hard time saying that raising a little cash for a buying opportunity is a bad idea. But I’m not sure simply selling out is the right way to go.

Forgive me if I am forced to delve into Europe and its debt again today.

Standard & Poor’s downgraded Italy’s credit rating by one notch yesterday. Italy has debt at 120% of its GDP, or around $2.5 trillion. Unfortunately, Italy has to roll over approximately $67 billion worth of bonds by the end of this year. With yields on Italian debt rising, this becomes more expensive.

The ECB has bought Italian bonds already. It may buy more. But that doesn’t change the fact that investors will become more nervous about Italy as Greece comes closer to default.

I’ve said I think Greece will indeed default on its debt, which totals around $500 billion.

The New York Times today says that the market is pricing in 60% default. That is, bond holders would get $0.40 one the dollar for their Greek bonds. It’s also reported that Euro-banks have written off Greek debt to the tune of around 20%. That means they still have a ways to go.

Merrill Lynch says that the worst-case scenario for French and German banks is a $543 billion hit. That would include the 20% they’ve already written down. Now, I haven’t seen the numbers so I don’t know how these banks would lose more in value than Greek outstanding debt. The point is really that Euro-banks have more work to do in writing off their Greek exposure.

For Greece to pay off its debt, at a time when its economy is shrinking 5% a year or more seems unrealistic. So why not just step up and state the obvious?

In fact, default – or debt forgiveness – is an option for mortgage debt in the U.S., too. I know the "pull yourself up by your bootstraps" crowd will disagree, but something has to be done about the housing market. Too many people are underwater, and despite low interest rates, many can’t refi their loans.

To me, a massive round of refis would help immensely. Get those underwater loans off the books, free up the associated loan loss reserves, and put a whole new mortgage debt structure in place.

The main impediment here seems to be credit scores. Anyone that’s struggling, or had a loan modification, probably has a credit score that precludes refis, regardless of income and job stability.

I would suggest one reason the Fed has kept rates low is to allow for refis. But the banks won’t/can’t engage in refis due to credit scores and the perceived risk.

For the record, I am a "pull yourself up by your bootstraps" guy. Nowhere is there more opportunity to better one’s self than in America. But at the same time, we as a country should also recognize the massive failure that the housing bubble represented. It was complete, from banks, to borrowers, to regulators, to policymakers, to analysts, to investors and economists.

This may not be the best time to bring it up, but 3Q earnings season is right around the corner. Alcoa (NYSE:AA) reports on October 11. No sector has received larger earnings revisions that the banks (and yes, those are lower revisions).

Last quarter, bank profits were massively inflated by returning loan loss reserves to earnings. Here’s a quick rundown:

JPMorgan Chase (NYSE:JPM) reported net income of $5.4 billion during the second quarter, boosted by a $1.2 billion reserve release. For Citigroup (NYSE:C), second-quarter earnings of $3.3 billion were helped by a $2.2 billion decline in loan loss reserves. Wells Fargo (NYSE:WFC) reported second-quarter net income of $3.9 billion, with its bottom line directly boosted by a $1.1 billion decline in reserves. For Bank of America (NYSE:BAC), the pain of a $8.8 billion second-quarter loss was somewhat eased by a $2.5 billion decline in loan loss reserves.

It will be very interesting to see how banks come in, and how much in loan loss reserves they can return.

At some point, banks will get healthy again. And they are essentially the last sector that’s still feeling the effects of the financial crisis (because they’re the ones holding the debt).

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