At 2:15 p.m. last Tuesday, the Federal Reserve threw all its collective might against the stock market, jacking up interest rates a half-percent and warning that more increases lie just down the road. At 2:16 p.m. the market yawned, took a look at the statement, and then, after a couple of nervous minutes, continued up on its merry way. Is the stock market just plain stupid? Doesn’t it know when it has been smacked on the head with a two-by-four?
In my turret at the hedge fund where I work, we call this kind of blissful reaction to a dreaded hammering the “Big Bad Event” phenomenon. That’s when a scary event, like an impending Fed meeting, looms so large that nobody does anything for weeks until we know the results. The irony here, of course, is that even if the event goes badly, people buy anyway! They are just happy that the event is at last out of the way so they can put their new money back to work. Recognizing when you are in the throes of one of these BBEs can make you a fortune, so let’s look more closely at why the stock market always seems to do the most moronic thing in the wake of obviously terrible news.
First, let’s stipulate some obvious facts, just so you know I haven’t lost my mind. When interest rates go higher, the economy cools because people borrow less money to buy and build things. So far, so good. When the economy slows down, companies that rely on the economic cycle for increased business don’t get that business, and their earnings fall short of well-crafted Street expectations. Normally, those shortfalls cause stocks to go down. So how can stocks rally on news that rates just went up?
Ah, now you are talking about two different things: the broad economy that the Federal Reserve worries about, and the amazing games that fund managers have to play to stay alive in a world where, if your performance falls behind benchmarks like the Dow and the S&P, you lose your bonus – and if you fall behind your peers, another fund manager takes your place next quarter.
On days when the Federal Reserve meets to discuss interest rates, as it did last week, you get to watch as the cool precision instrumentation of Greenspan & Co. crashes into the irrational frets of fund managers afraid of missing the next big move. During the weeks leading up to these deliberations, the fund managers have sat on their hands while millions of your dollars have come in over the transom – money that you expected to be invested in stocks. These managers watch the cash build up but are afraid to put it to work until they know the results of the Big Bad Event. But then, once the event occurs, they have no excuses. The money goes to work no matter what. Got it?
Fed meetings have come to define the quintessential Big Bad Event. They are widely telegraphed and hyped. Managers freeze like deer in Greenspan’s headlights, paralyzed by their own prudence. But once the event is over, they become financial bulimics, unable to keep the cash down, belching it out at every stock that gets too close. Some buy Pfizer and Pepsi, betting that the economy will now slow. Others buy Cat and Deere, betting that this is the last rate hike and the economy will soon reignite. Still others, the majority these days, buy tech, like Intel and Sun Micro, betting that rates don’t matter to these high-growth companies anyway.
What else drives managers to think that bad news creates an opportunity? The innate optimism that portfolio honchos must have to keep their jobs in this eighteen-year bull market. You have to believe that the rate increases will do their job and slow the economy just enough so no further rate increases are needed. Therefore, the last Fed tightening in a succession of tightenings is a fabulous time to buy, except no fund manager actually knows which hike is the last hike.
Tell me about it. Six years ago last week, in the midst of another set of tightenings to cool the economy, I made a knucklehead bet that higher rates would be bad for the stock market. The shame! I remember it like it was yesterday, because the Fed hike came two minutes after our second daughter was born. My partner, Jeff Berkowitz, called me in a panic on my cell phone in the maternity ward as our shorts – the stocks that we had bet against – rallied furiously right after a similar 50-basis-point increase by Greenspan. I had not yet learned the cardinal rule: Don’t short the aftermath of the Big Bad Event, regardless of how bad the event is. I got hit by the green projectile stream of fund dollars.
Maybe one day I will be able to look back and laugh about my frantic attempts to buy in, or cover, the Alcoa, the Phelps Dodge, and the Dow Chemical while the nurses footprinted our newborn. Six years later, I am still struggling with both my own stupidity and my heartlessness at that blissful moment. I know my wife will never see any humor in it.
Of course, not every hike is the last hike. The hike I blew in May 1994 turned out to be a terrific opportunity to dump your cyclicals right into my buying. I caused a temporary top in a whole slew of chemical, paper, and metals companies with my frantic bedside attempts to bring in my shorts. Once I had finished my frightened buys, the Fed leaked that it still had much more work to do in the rate-raising department, and those stocks spent the rest of the year plummeting. You can still see in the ten-year charts a blip-up created by my bozo buys, and then a stiff fall as the reality of really bad earnings set in.
Given the heated pace of this expansion, I wouldn’t be surprised to see one more round of increases before some real damage is done to the economy by the Fed’s massive hikes. These cyclicals could be in for another tranche of pain.
But the Fed still hasn’t quenched people’s zeal for stocks. In the wake of higher interest rates, they’re simply switching sectors. Many portfolio managers used last week’s hike to begin buying stocks that should do well even if we do get a recession.
So what the heck. We put $30 million to work before last week’s Big Bad Event, taking gobs of Philip Morris, Pfizer, and American Home Products, stocks that do well when the economy is slowing. During that brief moment between 2:17 and 2:40, as the market dipped, we took massive amounts of Intel, Sun Micro, Oracle, and Yahoo! as they temporarily swooned. By the end of the day, a ton of money was made as all of these stocks rallied. We had beaten and tamed the Big Bad Event at last.
James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund had positions in Pfizer, Pepsi, Intel, Sun Micro, Philip Morris, American Home Products, Oracle, and Yahoo! His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer’s writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites comments at email@example.com
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