Fed Schmed - Don't bring a knife to a gunfight with The Fed

Investors can't help but speculate on the various if-thens associated with what the Fed does and says and what an investor or trader should or shouldn't do in response or anticipation. The conventional wisdom goes like this: Since the bond market is discounting nearly a 100% chance of a 50 bps cut in the Fed Funds target rate, anything less would be disappointing and lead to a market sell-off in both treasuries and equities.

So most probably expect that 50 bps would be good for stocks and bonds, 25 bps bad and no cut a disaster. That may very well be the conventional wisdom; but it doesn't mean its true or you should trade or invest accordingly. So what should you expect a do or not do? The short answer is (whether you are bearishly or bullishly inclined) don't bet on instant gratification.

Alphatimer is of the opinion that this is not a good market for momentum trading either on the long or short side. No good for long momo because the major market trend is anything but up and not great for the short side because the rush to coordinated policy actions that we seen in the last two weeks is tantamount to market manipulation (in support of the long side) of the highest order. Instead of allowing an enormous amount of bad trades meet the rightful comeuppance, the Fed, Congress, and the White House are pulling out all the stops to bail out banks, brokers, tapped out consumers, over-extended homeowners, and credit insurers.

We think such concerted policy actions, whether you agree with them or not, are powerful forces which shouldn't be underestimated. It looks like we are on the cusp of the mother of all bailouts and we do not want to be on the other side of that trade. That's not to say that all is well again and the problems in the real estate market, credit market, derivative market or most importantly job market are all solved overnight.

There's little doubt that economic activity is contracting and that has reflexive implications that can only be reversed in time. And there's little doubt that the next 3-6 months of economic data are likely to be negative. However, we do think that enough is being done in terms of reducing market rates to help banks earn much better spreads and thus be better positioned to grow balance sheets sooner rather than later instead of shrinking balance sheets and lending less. Market rates would also soon decline sufficiently to allow homeowners to refinance and thus pre-empt a significant amount of foreclosures and billions more in credit derivative losses. If the Fed can only figure out how to bailout credit insurers, most economic fires will have been put out.

To the extent that it matters, we think it a safe bet to assume that the Fed knows that it must inspire confidence. That being so, we think that whether we get 25 or 50 bps; we are very likely to get re-assurance that the Fed is willing and able to cut more if/when necessary (which wouldn't be as bad as some think). Pundits might very well rush to criticize Bernanke and the Fed again, and highlight the economic problems. Keep in mind, however, that the market will not track coincidental to economic data; instead the market will look ahead.

In that context, this market quickly becomes a stock pickers market for shorts and longs. We expect no big move up or down in the indexes from here. We expect the negative market effect to lose its influence sooner rather than later. Therefore, we expect the short side loses the wind at its back. At the same time we also expect earnings disappointments to put a lid on potential upside. Its also quite possible that earnings disappointments may be shrugged off as the market looks forward. Either way, we think the next few weeks and months will be tough on bears and bulls alike.

If we are correct about the odds favoring either successful retests of recent lows or a basing process ensues, then this market will frustrate most. This looks like an environment where value investing thrives. We continue to think there is a good deal of value in the market. Long term value investors should look for opportunities to buy pullbacks in out of favor, absolute values with solid operating and financial performance. companies generating solid returns or well positioned to improve returns and free cash flow generation.