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Markets: No Way Out
New York: September 17, 2007
By John R. Stephenson

This week, all eyes and the hopes of the market are solidly pinned on the upcoming meeting of the board of governors of the Federal Reserve. The big thought on everyone's mind is: will the U.S. central bank (The Fed) cut interest rates? For most people, the answer is an emphatic yes . With gold at $700 an ounce, oil at $80, the U.S. dollar under pressure and wheat hitting an all-time high, would lowering interest rates make sense?

Maybe not! But with the credit markets in turmoil and the balance sheets of banks in serious question, Federal Reserve chairman Ben Bernanke will be under a lot of pressure to come up with some serious interest rate cuts to save the day for investors. The market is already betting on the strong likelihood of a 50 basis point cut. To disappoint, could usher in a wave of panic selling and a series of ugly days for the S&P 500 stock index.

The stakes couldn't be much higher. Tuesday's meeting and the accompanying announcement will be closely scrutinized by stock and bond traders who will be looking, not only for a cut in interest rates, but a signal that the Fed has changed its bias. Good luck!

Wheat has hit an all-time high. The stock markets have come roaring back and yet, inflation, as measured by the commodity complex and labor, is clearly on the rise. So far, Ben Bernanke has proven to be very adept as Fed chairman and has done an admirable job of steering the ship after the disastrous and ruinous course that was charted by his predecessor Allen Greenspan the so-called maestro . But what a tough road he has to hoe.

Clearly, the market thinks change is coming. Yet, the problem that needs fixing, is one of confidence in the credit markets that has spread to affect stock valuations. The problem is not one of fundamentals, but rather a story of greed and duplicity of a few of the moneyed classes in Greenwich Connecticut who flogged paper of dubious worth around the globe. Banks, once thought to be venerable institutions with solid credit and stable operations, have become mine fields of dubious value since these high-risk subprime loans were taken off-balance sheet and no one knows what these securities are really worth. It's as if the accounting department of Enron has suddenly morphed and took up residence in the major investment banks around the globe. Yikes!

No one is buying financial paper. It just isn't happening. And if it is, it is only stuff that you are one hundred percent sure of. If you are a bond buyer for an institution, are you going to take the chance that you're wrong about the value of the securities you're buying? No. It's just a career-limiting move to buy asset backed paper regardless of the rating. That's why the credit markets are facing their worst crisis in decades — financial institutions just don't trust each other. The commercial paper market is imploding and mortgages, except for government-backed agency paper, are not being written.

The housing market is on shaky ground. Foreclosures are high and set to go higher. According to investment bank, Goldman Sachs, home values could drop as much as 20% in an ensuing recession and noted economist Gary Shilling is suggesting the gap could be as much as 25%. Countrywide, a subprime lender, has just announced a 10-12,000 person lay-off, when weeks earlier they were looking at expansion. Could the U.S. consumer who represents 71 percent of the U.S. economy be ready to roll over and go to sleep? For my money, the answer is yes !

So with a U.S. recession looming, the credit markets in disarray, Ben Bernanke faces some tough choices. Should he lower interest rates to stimulate the economy and placate Wall Street — the very people who created the current crisis by mispricing risk in the first place? Or, should he ignore their cries and watch the stock market sell off in sympathy?

The Fed has already stated that they don't see it as their job to bail out shaky borrowers who took on loans they couldn't afford, nor the lenders who created these subprime monstrosities in the first place. But what a difference a week or two makes.

But if Bernanke bends to the pressure of Wall Street, and drops rates, an already weak U.S. dollar is likely to get weaker. Inflation, which shows no sign of abating, is on the rise as the current rally in commodities attests to. But would a rate cut accomplish anything?

In the short run, it would. A rate cut would instill a sense of confidence in the financial system that would be a benefit for a very short period of time. But longer term, it would do little, if anything. The real problem in the credit markets is one of credibility not liquidity. Pumping more money into the markets by lowering interest rates would do nothing to help buyers get more comfortable with the lack of transparency in the asset backed commercial paper market. No one is willing to bet the farm that the risks are fully disclosed. Maybe investors would have a year ago, but not today.

No matter what happens, this will be a choppy week ahead for investors. My betting is that the Fed does lower rates, at least a little. The U.S. will continue to limp towards recession as the housing crisis continues to unfold and draws the consumer into the fray as the disappearing wealth affect starts to take ahold of the all-important consumer confidence. Where it will end, no one knows.

For savvy investors looking to profit from the continued uncertainty, we continue to recommend investments in gold ETFs and gold producers which should benefit as the U.S. dollar weakens on the basis of the ensuing crisis with no way out.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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