Tuesday, January 29, 2008

Fed or Foe?

Tomorrow, the Federal Reserve Open Market Committee (the FOMC, or simply, the Fed) will emerge from deliberation and direct monetary policy in this country.

Futures have priced in a 50 basis point (.50%) cut.

Therefore, the Fed will cut at least 50 basis points. Many market analysts have pointed out that the tail (Futures markets) may be wagging the dog (the Fed), which is probably partially true. However, at this point, both fiscal policy (taxes, etc. - determined by Congress) and monetary policy (interest rates, etc. - determined by the Fed) seem aimed to prevent recession (or a slowdown) at all costs.

Fiscal "hawks" had been concerned about inflation in the past, but it now seems that cuts in favor of economic stimulation have taken priority. Little resistance has been seen when the Fed has cut in the past; as more write-downs and bad news continue to trickle out, I don't know why opposition would materialize now.

So 50 basis points is a virtual guarantee for tomorrow's announcement, while 75 is a realistic possibility. Here's how I see the market reacting:

  • A cut of 50 basis points will be immediately disliked. Financial stocks and homebuilders may sell off. (This will be bad for me, since I currently hold Countrywide shares and Hovnanian LEAP calls.) However, I think the market will eventually right its overreaction (whether it be by the end of the day, week, or in a few weeks).
  • A cut of 75 points will please the cheerleader analysts. The market will probably finish up a few percent. The downside? Much of the gains due to the announcement of interest rate cuts may be superficial and short-lived, considering monetary policy doesn't even affect the economy for six months.
  • A cut of 25 points will be disastrous for the markets tomorrow. Even if the Fed rationalizes it with improving economic data, the same cheerleaders will boo the decision as irresponsible and unreasonable.

Since I have already mentioned them, I'll reiterate an investment idea I've made before:

Buy Countrywide (CFC).

Countrywide is set to be bought by Bank of America sometime this year. When the deal closes, investors holding CFC shares will get .1822 BAC shares for each one of CFC. As of the market close today, a share of Countrywide costs $6.31 and BAC sells for $41.94.

If the deal closed tomorrow, Countrywide would essentially be bought for $7.64 per share. Or, to look at it another way, you can buy a Bank of America share for $34.63 by buying the corresponding amount of CFC.

Of course, there is some possibility the deal won't close. However, BAC's deal terms cited only unknown, unexpected, and misleading information as a reason for breaking the deal. Countrywide reported earnings today, losing a ton of money, but nothing was surprising or misleading, and BAC said nothing about any problem going forward from this point.

Yes, there is inherent risk of owning a financial stock right now. But the arbitrage spread is still over 20%, so there's lots of money to be made in a very questionable market. If you're looking to own Bank of America over the next 5, 10, or 20 years, this may be your best opportunity.

If the Fed doesn't please tomorrow, both BAC and CFC may get hammered. It's certainly going to be a volatile few months for financials, but the reward may be worth the risk.

For my sake, and for the portfolios of millions of investors like me, I hope that the tail keeps wagging the dog tomorrow.

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