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  Posted on: Thursday, December 18, 2008
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The Fed's Big Experiment

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We have three major thoughts on the Fed's latest policy.  First, it confirms that the Fed will buy almost anything and lend to almost anyone to prevent the economy from going into a deep depression.  Second, it reveals how much the Fed fears the possibility of a deep depression, and that their efforts to date have may not have been enough.  Third, the negative feedback loop underway in the credit markets and economy are so severe that the Fed is willing create enough dollars to raise the worry of inflation at some future time, since the potential of deflation is far more worrisome at the moment.

The new policy is aimed at dropping the fed funds to zero and to employ aggressive quantitative easing in the hope of lowering long-term interest rates and unfreezing credit.  The Fed will buy longer-term Treasury bonds (up to 6 year maturities)  and further expand its lending facilities to include securities backed by credit card, student, vehicle and small business loans.  The Fed's unprecedented action, together with President-Elect Obama's developing plan for a huge fiscal stimulus, reflects a global financial and economic crisis that dwarfs anything seen since World War II.

The economy has fallen off a cliff in the last few months and has begun to feed on itself in a dangerous downward spiral as a result of the credit freeze, declining wealth, increasing unemployment and a lack of savings. Payroll employment was down by 533,000 in November, the biggest drop since December 1974.  The last three months alone have seen a drop of 1.256 million jobs.  Initial unemployment claims have averaged 544,000 over the last four weeks, the highest in 26 years.  Industrial production was down 0.6% in November and is declining at an annual rate of 9.8% in the 4th quarter.  Planned auto production is down in December while the ISM Manufacturing Index has dropped to 36.2, the lowest in 26 years.  November retail sales were down 7.4% from a year earlier, a record going back to the 1960s. Consumer spending is likely to remain under pressure for some time as a result of the loss of jobs, a major decline in wealth, the difficulty of getting credit and the need to increase savings. 

The big question on everyone's mind is whether the unprecedented monetary and fiscal plans will work.  That, of course, raises the question as to what the word "work" means in this context.   In our view the plan has a good chance of working to the extent of staving off a potential depression.  The policies being undertaken and proposed are far more extensive and more timely than anything initiated during the great depression.  However, it would be a mistake to think that we are merely in a typical post-war garden-variety recession.  We think that the economy is unlikely to bottom before the 4th quarter of 2009, and that we would be very fortunate to achieve that result.  There is no textbook solution for what ails the global economy, and the authorities are throwing everything at the problem with the hope that it works.

The unprecedented policy actions have also raised the possibility of highly excessive money supply and a big surplus of dollars leading to inflation.  In our view that is certainly a legitimate worry, and something to monitor in the period ahead.  However, right now the authorities are right to worry about the potential of depression and deflation first.  Inflation would not take hold until we get a strong economic recovery with labor scarcity pushing up wages and production straining available capacity.  We are such a long way from that eventuality that we have plenty of time to monitor the data as we proceed (and we are using our own indicators to determine that risk presently). 

As for the stock market, it seems that investors have priced in the current bad news, but, perhaps, remain too sanguine about the length and depth of the recession.  At today's close, the S&P 500 was selling 13.4 times trendline reported (GAAP) 2008 earnings of $66, compared to an average P/E ratio of 10.4 at the bottom of the last 10 bear markets associated with recessions.  Moreover, in five of these instances the smoothed P/E ratio bottomed at 8 or under.  We note that bullish observers are using an operating earnings estimate of over $84 for 2009.  However, S&P's reported (GAAP) earnings estimate for 2009 has now dropped to just over $42 (down $7 this week).  In the past, secular bear markets troughed at 8-to-10 times reported earnings, NOT operating earnings, which didn't even exist until 1984.  In terms of timing,  on average the market bottomed five months before the end of the recession.  Therefore the odds are that unless the economy starts to recover five months from the November 2008 bottom, the market decline is not over, although a bear market rally is always a possibility between now and the eventual low.        

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