The Fed's Economy: Too Good To Be True?

A fair bet for Tuesday's Fed rate decision is a quarter-point reduction in the federal funds. Otherwise, there's liable to be a run for the exits by panicky investors. With oil above $80 a barrel and gold above $700 an ounce, the status quo can't be what Chairman Bernanke thinks is the proper course of action.

But truth is, we have a long way to go in the unwinding of leverage; the solvency issues among borrowers, builders and mortgage providers; the onslaught of credit downgrades; and the recalibrating of terms on multibillion-dollar private equity takeovers. Proof of the pudding: The Bank of England and the European Central Bank are having to pour reserves into troubled spots in the financial system.

Croesus can't help thinking the equity markets are acting way too comfortable. At 13,400 on the Dow, we are only 600 points, or less than 5%, down from the 14,000 peak that ignored the signs of trouble in the credit markets.

Are you going to tell me that the averages will lose only 5% when the commercial paper markets seize up and the housing market, which fed the economy's surge, is very nearly in free fall? This is an example of the equity markets not understanding the credit markets. It shows that stock and debt markets can operate "like two parallel universes," as my friend Christopher Wood puts it in his Greed & Fear market letter.

If you're a worrywart, consider Morris Offit's warning in a memo to clients of Offit Capital Advisors that "the Fed's monetary tools may be inadequate to meet today's challenges." Offit, with decades of experience in fixed-income markets, believes "the Fed cutting the Fed funds rate may have inconsequential value other than signaling investors that it is concerned about maintaining economic stability in the face of an eroding housing market."

So, what have we learned since mid-July?

First, the use of leverage to reach for yield can be destructive of values. And that leverage was a disguise for the liquidity we thought would never allow the credit markets to freeze.

Second, arithmetic models don't work when the system is strained. Look no further than Goldman Sachs hedge funds on that score.

Third, it's unwise to invest in vehicles like collateralized debt obligations and collateralized loan obligations that you don't understand. Or to buy short-term paper issued by off-the-balance-sheet financial units of major banks that were not transparent to the investment community.

Fourth, the regulatory system is flawed. Ben Bernanke was wrong in saying the subprime problem wouldn't spread to other areas of financial markets. The Fed, ultimate guardian of our economy, was blindsided. I repeat: The Fed was taken by surprise. To be fair, none of the central banks realized that even the saving grace of spreading the risk of new products and innovations (like credit default swaps) would not of themselves prevent those who had been too optimistic from suddenly turning pessimistic. That liquidity would freeze.

Listen and mull over what Howard Marks of Oaktree Management has to say in his latest letter to clients: "Risk cannot be eliminated; it just gets transferred and spread. And developments that make the world look less risky usually are illusory, and thus in presenting a rosy picture they tend to make the world more risky. These are among the important lessons of 2007."

What investors should focus on in these dangerous times, Marks insists, is "ensuring the protection of capital under adverse circumstances is incompatible with maximizing returns in good times, and thus investors must choose between the two. That's the real lesson."

So, my take is that the bubble of investor psychology could still become deflated whether there's a quarter-point reduction in the fed funds rate or not. A 5% decline in the stock market amid the credit bubble bursting is just too good to be true--for long.