It's All About to Hit the Fan
By Jeff Clark
September 13, 2007

Don't worry. The Fed will save us.

Homebuyers and speculators went out on a limb and paid top dollar for beaten-down fixer-uppers. They financed the purchases with adjustable-rate, negative-amortization mortgages that required no income verification and no down payment. And now, surprise of all surprises, the interest rate on those mortgages has tripled and so have the monthly payments. Many face the real prospect of foreclosure.

But don't worry. The Fed will save us.

Consumers spent every dime they earned on flat-screen TVs, giant SUVs, miniature iPods, and $12 golf balls designed to go 300 yards straight down the fairway every time. When they ran out of money and couldn't afford to keep up with the Joneses, consumers took out home-equity lines of credit and tapped into the inflated appreciation of the roofs over their heads. Consumers now face the real prospect of bankruptcy.

But don't worry. The Fed will save us.

Banks and consumer finance companies were more than happy to lend money to these fools. After all, they could always sell those loans to brokerage firms, which packaged them into AAA-rated fixed-income products and sold them to gullible investors, who were willing to take on ridiculous risks in order to capture an extra 0.25% return. Now banks and consumer finance companies are on the ropes because they can't unload the last – and largest – batch of stupid loans. Brokerage firms are suffering because they can't unload the last – and largest – batch of fixed-income products.

And those gullible investors are on the ropes because, as it turns out, the extra 0.25% return on principal makes it quite likely they'll never actually receive a return of principal.

But don't worry. The Fed will save us.

Stocks are up this week. Gold is up this week. Oil is up. Bonds are up. And the dollar is down.

All of this is happening because the market expects the Fed to cut interest rates by 0.25%-0.50% next Tuesday.

It is widely believed that if the Fed starts cutting interest rates and injects liquidity back into the market, then all of our problems will just go away. I wish it were that easy…

Adding additional liquidity right now is like giving a bottle of tequila to a drunk. It might quiet him down for the moment, but it only exacerbates the problem.

The Fed will most likely cut its fed funds target by 25 basis points. And the market is already anticipating at least that much. So if investors finally get what they want, and what they've already factored into stock, bond, and commodity prices, then there really isn't much upside remaining over the short term.

The real question is… What happens if the Fed doesn't cut rates? Or if it doesn't cut rates as aggressively as anticipated?

In my view, there isn't a whole lot of upside to this scenario and there's an enormous amount of downside. In fact, the term "financial meltdown" comes to mind.

Understand that I'm not predicting a disaster. Nor do I hope that one occurs. But the odds of a meltdown – which are normally something like one in a kazillion – are certainly higher right now. And that is definitely not being discounted by the market.

But what about those of us who have prepared for this? We've paid down our mortgages. We pay off our credit card balance every month. We save 10% of our gross income every month. And we avoid the useless extravaganzas that have gotten our neighbors in trouble.

Sadly, the Fed can't save us.

We're faced with the same dilemma as the deep-sea diver who hears the message from the ship above, "Come up at once. We are sinking."

A financial meltdown affects everyone – saver and debtor alike. You can offset your risk with prudent financial planning, and a well-timed short sale or two. But a financial tsunami will sink just about every ship.

I truly hope the Fed can save us… and it's not time to go sit in your underground bunker just yet. But I do think the smartest trade right now is to fade the majority. That means reducing your exposure to conventional stocks and commodities. And loading up on cash.

No matter what the Fed decides next Tuesday, financial assets are likely to selloff and the dollar is likely to rally. I know that's not the popular opinion, but that's what the evidence is telling me is the right move right now.

Also… how often is the popular opinion the right one?

Best regards and good trading,

Jeff Clark