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Has the Fed Gone Crazy?

Written by Briton Ryle
Posted October 14, 2018 at 8:00PM

Well. That was fast.

In this age of machines and ETFs, there just aren't slow grinds to the downside. Instead, we get gut-wrenching plunges that push indicators from extremely bullish to extremely bearish in a matter of two or three days...

Remember that VIX crash back in February, when the S&P 500 corrected by 13%? It actually started during the last couple days of January. The high for the S&P 500 came on January 26. And it didn't really get back to rally mode until May 3. But the bulk came during just three sessions between February 2 and February 8.

If you blinked, you missed it.  

The machines make sure selling is relentless. And ETFs make sure that when the selling starts, it's everything.  

It's a pretty wicked combination. It looks very much like panic selling. Though we really don't how it will look if/when some real panic selling hits. If we can get 800–1,000-point drops on the Dow for no good reason, does that mean we'll see 3,000-point drops if we get another 2008–9 financial crisis? 

The best thing any of us can do to navigate these types of sell-offs is know what's causing investors to suddenly hit the sell button. Knowledge is the best antidote for fear.

So that's where we're going today: to take a look at what crushed the Dow 1,400 points in two days last week.

Interest Rates or Trade War?

I've seen a lot of commentary that investors are really worried about interest rates going higher. You've probably heard the supposed cause-and-effect relationship between the Fed hiking rates and the economy hitting recession. But let me tell you: Rising interest rates do not cause recessions. It's the bad decisions that get made when rates are low that eventually cause recessions. 

Did Greenspan's rate hikes cause the financial crisis? Of course not. A 500-point rate hike might've popped the internet bubble, but it was 9/11 that really hit the economy. 

So now the Fed has hiked interest rates to 2.25%... and people are worried that's going to bring it all crashing down? Please, just stop. Rates were 5.25% before the financial crisis. And the hike that broke the internet bubble took rates to 6.5%.  

Of course, it's a relative thing, how much rates have gone up and how fast. You'd be hard-pressed to say rates have risen a lot, or fast.

But still, today's first-time homebuyers might've only been in middle school the last time rates were "high." All they know is a mortgage is more expensive today than it was a year ago. Same with a new car payment. And that's kind of the point: Make money more expensive, and people tend to borrow and spend less. 

On the corporate front, it is likely that higher rates will affect stock buybacks. Companies have been buying back about $1 trillion of their own stock for the past six years. And that's been a solid source of upside for prices. Problem is, they've borrowed to do it. Not because they don't have the cash — they do. But when rates are so low, it makes sense to borrow at the low rate and keep the cash on the books and invested. 

Companies aren't likely to start spending their cash, either. The most obvious response to higher rates is simply to borrow less. Which means fewer buybacks. But of course, fewer corporate buybacks aren't going to make the U.S. economy slow down...

When it comes to a slowing economy and the potential for recession, we have to look to what could kick off the vicious cycle. Less spending → lower profits → corporate layoffs → less spending.

The answer is tariffs.

The Ford Problem

Last week was not great for Ford. The carmaker had to admit that China sales were down over 40%, that its annual profit would be $1 billion lower than last year, and that it was going to restructure its workforce and layoff thousands. Hello, vicious cycle!

Now, Ford has some issues of its own that are contributing. But pretty much all automakers saw their sales decline in China for the last three months. It's the tariffs and trade tensions. 

China's stock market has been selling off since February, when the first tariffs were announced. The Chinese economy is weakening.

You could say this proves that the tariffs are working, that China will be forced to negotiate. But tariffs will hurt the U.S., too. And Europe. Because the bottom line is that China is now an end market for Ford, for Apple, for Harley-Davidson, for Nike, for Starbucks...

And it's also the most important end market in the world due to the combination of size and growth. Now, like with Ford, major corporations are at risk of joining the vicious cycle that starts with slowing sales in China. 

I think the risk of recession in the next months is high. And it's a virtual certainty if there's no trade deal with China. 

You know the financial media will run around like headless chickens, shrieking, "Trade war! Trade war!" And given the elevated valuations, the downside for stocks could be pretty decent. But ultimately, any tariff-related recession ought to be pretty mild. So here's the game plan...

Check through your stocks, pinpoint the ones that aren't great, and get rid of them. Keep the great ones. And start putting some cash aside to buy more great stocks when they get cheap. That's it. Pretty simple. But as Buffett said, the most important trait for an investor is patience.

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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