December 20, 2008

Another relatively flat week:  the S&P up under 1% and the Dow down about half a percent.   The bad economic news kept on coming: industrial production slumped, building starts and permits plunged, CPI fell to historic lows, jobless claims stayed above 550,000 and leading indicators fell.  The biggest news was the Fed’s move towards quantitative easing, Japan style.  After dropping its target lending rate to near zero, the Fed essentially pronounced that it will increase the supply of credit as much as needed to stabilize prices and avoid deflation.  The equity markets initially cheered the news, but then  retreated to digest the gravity of the situation:  what happens if the Fed’s programs don’t work, as in Japan? 

U.S. banks are hoarding cash, depositing it right back with the Fed.  As they deleverage, the banks are not–by definition–lending as much as they did in the past.  And their customers–corporate and consumer–are not demanding as much credit as they did in the past.  Therein lies the problem.  Neither the Fed, nor the President, nor Barney Frank can force the reluctant lenders to lend to reluctant borrowers. 

But what if the Fed keeps printing more dollars?   The currency markets may have punished the dollar this week, but the treasury market soared–to historic highs–seemingly shrugging off the potential threat of inflation down the road.  Today, it seems, that investors around the world are worried more about deflation and are averse to assuming risk.  So they’re content to earn essentially no yield in 3 month T-Bills and only 2% in 2 year Treasuries.   This suggests that they expect further economic deterioration and prices to continue falling.  Obviously, this is not a good sign for equities.  It is probably a major reason why we have not seen a major and sustained rally beyond 900 and on to 1,000 in the S&P500.  We reached the 800’s in October, and we’re going to need to see signs of economic improvement to give buyers confidence to push the market up much higher.

On a positive note, the equity markets are not falling much.  Again this week, despite the steady stream of bad news, the market did not suffer from panic sell-offs, as it did in October and November.  This suggests that a bottom, at least in the short term, is being established.

Like thin ice, unfortunately, this bottom may prove to be fragile, with tragic consequences.  In just a few weeks, Q408 earnings will begin to stream in.   If they’re ugly enough, and if the outlooks are ugly enough, this might just crack the support levels built up around 850.  Throw in a few major nasty blow-ups (a big corporate or sovereign default, a significant bankruptcy, or even a revolution or war in a developing or emerging nation) and the panic sell-offs could easily return, pushing the S&P down into the 700’s and even the 600’s. 

In short, the upside is limited, but the downside could be painful.   It’s no wonder that so much capital is playing it safe.  At least over the next three months, it might pay to stay off the ice.

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