The markets had an excellent first half of the week, gaining back some of the losses of the current correction. One explanation that I have seen offered for the lift in stock prices is the expectation that Federal Reserve Chairman Ben Bernanke will announce during his speech tomorrow in Jackson Hole, Wyo., that the Fed will take new, extraordinary actions to address the slowing U.S. economy and the market's dour outlook. If that is true -- and it seems utterly plausible -- then markets will be disappointed tomorrow and U.S. stocks could experience a decline consistent with some of the swings we witnessed this month.
3 reasons that aren't enough
Let's take a look at the main causes of the August correction and whether they'll motivate the Fed to act:
- Standard & Poor's downgraded the U.S. from triple-A to double-A. The U.S. debt overhang was no secret; instead, S&P were acting on what it correctly perceived to be a deterioration in policymakers' ability to address the problem. In this arena, all the Fed chairman can do is to advise politicians of the risks inherent in an unsustainable debt trajectory (which he has already done).
- European sovereign debt crisis: Here, the Fed must consider some of the potential knock-on effects if the crisis were to flare up to a new level of intensity. There are some signs of stress in interbank lending markets (the markets in which banks borrow from each other), but we are nowhere near the breakdown that occurred in the wake of the Lehman bankruptcy. Furthermore, the Fed has already taken steps to head off the possibility of a similar situation by renewing its dollar swap lines for foreign central banks, i.e., dollar liquidity that the European Central Bank can lend on to any European bank that is having difficulty obtaining funding in dollars. One unnamed bank made use of the facility in the amount of $500 million. In addition, the Federal Reserve Bank of New York has increased its scrutiny of the American subsidiaries of European banks, demanding that they hold more dollars in cash, in order to minimize the impact of a problem at the European parent.
- The U.S. economy is showing signs of slowing down and the risks of double-dip recession have increased: These risks fall squarely under the Fed's purview; however, a double-dip recession is no certainty at this stage. Even if it were, the Fed does not have the same margin for maneuver it had last August. Inflation has increased in the emerging markets over the past 12 months; a QE3 could well exacerbate this phenomenon and threaten growth and stability in these markets. This would be particularly problematic with regard to China -- a major contributor to global economic growth right now -- which is already battling inflation.
- Finally, let's not forget that Bernanke has only recently thrown markets a bone in the shape of an extension of the zero-interest rate policy over the next two years. It's a very dubious notion to believe that he will follow this up so soon with another extraordinary policy measure when very little has changed since he announced that at the beginning of the month.
It's not coming
In sum, investors should expect no announcement of a QE3 or any other extraordinary measure -- it will not be forthcoming from Bernanke. Assuming the market is factoring in a major measure from the Fed (which I do think is the case), there will be a sell-off on Friday that I'd expect to produce a decline in U.S. stocks on the order of 3% to 5%. For short-term traders, this could be a problem -- particularly for those who leveraged.
It doesn't matter
The good news for long-term investors is that whatever the outcome of Friday's speech, either action or inaction on the part of the Fed will have no effect on enduring businesses' value. If you own pieces of these businesses, there is no need for concern. If you don't, know that fractional ownership of some of these businesses are on sale at a discount in the stock market, whether it be Berkshire Hathaway
