Back on April 12th we wrote a comment "Put Yourself In Their Shoes" where we concluded that any reasonable person could not consider raising Fed Fund rates into a decelerating economy exacerbated by housing problems. We also concluded that a reasonable person would not cut rates with the potential inflationary outcome that exists today. Mr. Bernanke’s comments yesterday confirmed this thought process. They are in a box that is so deep, that moving Fed Funds in either direction is presently impossible.
First Mr. Bernanke told the House Financial Services Committee that growth in the economy will be a bit slower than the Fed projected in February. He also acknowledged that the problems in sub prime loans and other housing related problems could spread to other areas of the economy and could weaken GDP even more. He stated, "another risk is that the housing slump could turn out worse than expected, sapping consumer spending and possibly causing overall economic growth to be weaker". He also stated, "Even if the demand for housing were to stabilize somewhat, the pace of new home building will probably fall as builders work down excess stocks of unsold houses. Rising delinquencies and foreclosures are creating personal, economic and social distress for many homeowners and communities - problems that likely will get worse before they get better".
Even with these very worrisome comments on the economy, Mr. Bernanke still stated that "inflation remains the chief concern". He went on to say that "one risk is that energy and commodity prices could continue to rise sharply, boosting the prices of lots of other goods and services and thus spreading inflation through the economy".
We concluded in our April comment that the Fed would have to keep the Fed Funds rate unchanged unless some future economic data comes out that would force their hand one way or the other. We also concluded that if this future data were so strong it forced the Fed to lower rates to avoid a recession, it would not be positive for the stock market (especially with the weak dollar). If the Fed was forced to raise rates to avoid a significant inflationary environment, it would not be a positive for the market. The worst-case scenario would be if inflation slowly rose while the economy slowed ("stagflation") would be very negative for the stock market.
The only positive future economic data that would be positive for the market would be the "Goldilocks" scenario of slowing inflation with a fairly strong economy. This scenario we believe to be a long shot.
With all of this said, the market has broken out of a long-term trend channel to the upside. This break out was surprising and shocking to us - and while we do not believe this Mr. Magoo market will stay strong we also know that there are times to "get out of the way". This means that individual investors should cover any positions that have unlimited losses such as common stock shorts that have broken out or index future shorts. We still believe that positions like puts and other bearish limited loss positions make sense and are good hedges against a long portfolio of stocks
