Is The Worst Really Over?

Source : The Business Times, September 23, 2007

According to conventional thinking, an interest rate cut has to be good for stocks. After all, the last time the US central bank started slashing its rates some seven years ago, it eventually reflated a deflating Wall Street and brought about the run of the past three years.

So it's been that Tuesday's decision by the Federal Reserve to cut its federal funds rate by 50 points instead of the widely-expected 25 has been hailed by most analysts and brokers as sufficient to ensure the bull market resumes.

In its Q4 Strategy Outlook for example, BCA Research said 'monetary reflation will be the dominant force in global financial markets and equity performance will be strongly influenced by this theme', adding that rate cuts will mean lower borrowing costs and better profits ahead. Not surprisingly, it recommends staying positive on stocks.

Most other market-related outfits have arrived at a similar conclusion. One of the arguments used is that the rate cut, which could well be the first of many to follow, should kickstart a flagging US economy that was buckling under the weight of a crashing housing market.

Then there's the India and China angle, which can always be relied upon to induce clients to keep buying when all else fails.

Regular readers of the business pages would be familiar with this line of reasoning, which in a nutshell says that even if the US slides backwards, the engines of global growth have shifted to this part of the world and are being driven by the emergence of India and China.

So it doesn't really matter if Fed chief Ben Bernanke and his economists have acted too early or too late or should not have acted at all, Asia is insulated anyway.

All of this reasoning is fine - it sounds plausible, it's well-grounded and is easily understood even by the most naive of investors.

And it may well be that US rate cuts are just what every market needs to get things up and running again.

But is there a flip side that perhaps has been underplayed, or glossed over in the eagerness to get everyone buying again?

Put differently, are investors at risk of making the same mistake they did two months ago, which is to underestimate the magnitude of risk in the market?

First, the last US easing cycle came when Wall Street was being seriously battered by Nasdaq's crash. This time, the Dow Jones Industrial Average was only 5 per cent off its all-time high when the Fed cut rates on Tuesday.

Similarly, the Straits Times Index was only 4-5 per cent below its own all-time high when the rate cut was made. Check all the other markets and the numbers are roughly the same. Is the visible upside really that attractive?

Second, is it possible that the rate cut will not have much effect on the crashing US property market and that the rally of last week was a knee-jerk relief rally that might soon fizzle out?

Third, if oil is at an all-time high above US$81 and if core inflation picks up, will the Fed take back the rate cut? If it's forced to do so, what might the impact be on Wall Street?

Fourth, when the Japanese economy crashed in the late 1980s under the weight of its own over-hyped property market, its government brought interest rates down to zero but was unable to head off a recession that has lasted for more than 15 years. Is there any reason to think that the US situation could be different?

Finally, there's always the nagging worry that the sub-prime story has not fully played out yet and that there could be more shocks in store. Last week's wobbles came not from Wall Street but from Europe, where the ripples are now being felt and could start appearing in bank earnings.

The best that can be said that although the chances of markets regaining their stability have increased compared to a month ago, the risks have not abated proportionately. Glib urgings to buy and keep buying without equal weightage given to risk should be digested critically and investors have to remain open and cognisant of the likelihood that the worst may not yet be over. -- BT