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Everyone who the media talk to seems to want the Fed to cut interest rates next week.
Reducing interest rates, we are told, will prevent 2 million homeowners from losing their homes and restore calm to the mortgage industry. Bad economic news strengthens the case for a rate cut because it implies that lower interest rates would lead to higher growth, instead of higher inflation. Bad news also lends itself to attention-grabbing headlines, which sell newspapers, increase viewership and drive page views. It's no wonder that bad news, such as Friday's weak jobs report, makes headlines.
Between now and next Tuesday's Fed meeting, I expect to see the importance of every piece of bad news exaggerated in order to increase the pressure on the Fed to reduce interest rates. But once the decision is announced, I expect most of the people the media always go to for instant analysis will support the Fed's decision -- whatever it is.
Since the financial futures market is already pricing in a cut of 0.25% in the fed funds rate with 100% certainty, a lot of people are going to be surprised if interest rates are not reduced next week.
I think this is a likely scenario because most of the data indicate the economy has been running pretty close to full capacity for some time now. Evidence that an interest rate cut is needed is starting to emerge, but it is not at all clear. Given Fed chief Ben Bernanke's track record of letting data guide policy, I think an interest rate cut is not in the cards for next week.
Investment strategy
Changing investment strategies involves transactions costs and tax consequences. These costs are justified when you think market conditions have fundamentally changed.When I selected my portfolio, I expected that the economy would grow at 2% to 3% this year. The meltdown in the subprime mortgage market will have a lasting impact for many companies, but it so far it has not changed my outlook for the economy. Over a two-year investment horizon, the difficulty in the subprime mortgage market will look like a blip rather than an inflection point for the economy.
The trade I am making today is designed to recognize some losses for tax purposes, while maintaining the same investment upside. Both Lufkin Industries (LUFK, news, msgs) and Patterson-UTI Energy (PTEN, news, msgs) are energy service companies. Both have come down as fears of an economic slowdown have emerged. Although I still like Lufkin's prospects, I like Patterson's more. By selling Lufkin, we will get some of our losses back in the form of tax savings. Putting the proceeds into Patterson keeps the portfolio weight in energy stocks about the same, so if we are right about energy, the portfolio's upside will still be about the same.
This trade will improve the after-tax returns of this portfolio. Taxes can take a big bite out of an investor's return, so I think it's important to consider the tax impact of my decisions, even though Strategy Lab doesn't account for them.
If you are holding on to stocks in which you have losses, you might consider doing a similar trade. Find a stock that benefits from the same factors that would make the stock you own appreciate. Then sell the stock you own, and buy the other one.
Here are some examples: If you have a loss in Valero Energy (VLO, news, msgs), consider selling it and buying Tesoro (TSO, news, msgs), another major independent refiner. If you have a loss in the Vanguard 500 Index (VFINX) fund, consider selling it and buying the Fidelity Spartan S&P 500 (FSMKX) fund. In this way, you can take advantage of this market downturn to reduce your taxes without disrupting your investment strategy.
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