Expect a Rate Cut Today

First and foremost, remember that the U.S. economy is like a battleship -- it is very large and very resilient. It has the capability of absorbing many blows and still remain afloat. 

There is still a chance that we come out of this mess relatively unscathed.  What do I mean by relatively unscathed?  I mean an economy and financial system that is still recognizable to most Americans.  It seems clear that we are headed into (or more likely are already in) a pretty deep recession, but another depression is not a foregone conclusion. 

Much will depend on the skill of the policy makers over the next few months.  We are extremely fortunate to have one of the world’s foremost experts on the causes of the Great Depression, Ben Bernanke, as the chairman of the Federal Reserve.   So far he has shown incredible flexibility and responsiveness to this crisis. 

While I had been expecting him to hold rates steady through the end of the year and then possibly increase them early next year, that is no longer the case.  I expect that we will have a cut this afternoon, perhaps even a 50 bp cut.   The Fed has to intentionally take what are normally highly inflationary steps to offset a massive deflation that is taking place due to massive deleveraging.  However, the Fed does not have that much ammo left, the Fed Funds rate is already down at an extremely low 2.0%.

The crisis is not over, not by a long shot.  This will particularly be true if American International Group (AIG - Analyst Report) goes under today or tomorrow.  As of last week, analysts were looking for a year-over-year decline in total net income of 49.8% for the Financial sector.  Those estimates are no longer operative, and I seriously doubt we will have much of a recovery in the fourth quarter. 

For starters, it may be a very different sector than a year ago.  Several of the most important firms a year ago may not even be in the index by the time third quarter earnings are reported.  These obviously include Lehman Brothers (LEH), Fannie Mae (FNM) and Freddie Mac (FRE).  Merrill Lynch (MER) will most likely still be trading in time for third quarter earnings, but will most likely be subsumed by Bank of America (BAC - Analyst Report) by the time the fourth quarter rolls around.  AIG is a real question mark, as is Washington Mutual (WM - Analyst Report).  The federal takeover of the GSE’s will require a big round of write-offs in many corners of the banking system, as will the counter party exposures to LEH.

The S&P 500 as a whole was expected to show just a 3.0% decline in year-over-year net income for the quarter.  In large part due to the financials, that is no longer operative.  The reality will most likely be closer to the 21% decline we experienced in the second quarter.  The big driver on the positive side for earnings was expected to be the Energy sector, up 49.5%.  As the world sinks in to a deep recession, oil prices are plunging.  Profits will still be up for the sector, but it is unlikely that they will be up that much, and the plus 30.5% expected growth in the fourth quarter is looking increasingly unrealistic.

It is time to hunker down a bit and worry more about the return OF your capital rather than the return ON your capital.  There will be great chances to buy good firms at great prices in the future, but now is not the time.  For the time being, look to companies that have very strong balance sheets and which have products and services that demand holds up for in good times and bad.  Consumer Staples and Health Care top that list.  Electric Utilities may be worth considering. 

I still think that as the world comes out of this downturn, you will want to be in Energy and Materials stocks.  However, both the supply and demand curves for oil are highly inelastic, and this downturn is destroying lots of demand, hence prices are plunging. 

I would continue to stay far, far away from the Financial sector and the Consumer Discretionary sector.  Employment is going to continue to fall and wage growth is very weak.  Consumer credit will become very difficult to obtain.  Thus, spending on big ticket discretionary items is likely to be very constrained going forward.

Good policy moves will be essential to ward off the multiple blows the economy is on the receiving end of.  Just because we are a battleship does not mean we are invulnerable.  After all, eventually even the Bismarck sunk.  Still in a big storm, I would rather be on a battleship than a small boat.

Read the full analyst report on AIG.

Read the full analyst report on LEH.

Read the full analyst report on FNM.

Read the full analyst report on FRE.

Read the full analyst report on MER.

Read the full analyst report on BAC.

Read the full analyst report on WM.

Read the full analyst report on FRE

Read the full analyst report on FNM

Read the full analyst report on MER

Read the full analyst report on LEH

Read the full analyst report on AIG

Read the full analyst report on BAC

Read the full analyst report on WM