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 4^th 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 4^th 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.        

We have made quite a few predictions over the past years and even over the past few months.  As you know, we wrote a special report in September of 2003,  "The Catalyst for the Next Deflationary Bear Market---Real Estate".  We also wrote on December 22, 2005 "Softening Housing Market Puts Global Economy at Risk".  In fact we discussed housing so much that if you click on any recent weekly reports and scroll down to the bottom of the recent reports on the right you will find "Archives Search" and if you type in "housing" you will find that there were 262 reports that dealt with the housing problem since first writing these reports.

We have predicted a severe "global recession" for many years and if you search the archives for that it appears 17 times.  Just recently we predicted (and showed in all the charts of "The Cycle of Deflation") that there would be a race by all the Central Banks to lower interest rates in order to enhance exports.  Just last week the Bank of England lowered their rates from 3% to 2% (lowest since World War II) after lowering them in November TWICE. The ECB lowered their rates the most in their 10 year history from 3.25% to 2.5%.  They also lowered rates TWICE in November.  Japan's central bank lowered their rates as well as Switzerland's, the Czech Republic's, Korea's, Australia's and the list goes on and on. 

We predicted in "Obama May Want a Recount", November 6^th that Obama would inherit a $1 trillion or more deficit in the coming fiscal year.  We were probably low with that prediction since just today it was reported that the November budget deficit registered a new record of $164.4 billion and is on track for a record deficit of $1 trillion. A deficit of $1 trillion for the year would set a new record as a percent of GDP since World War II at 6.7%.

On July 3^rd we predicted that commodities would peak shortly and decline with the severe global recession dampening the demand.  The next week, July 10^th in "Explanation of The Predictions Made Last Week" we stated, "Many investors believe that the stock market has been going down for the past 8 months because of the rising prices of energy and food.  We believe that the market will continue down with the decline in the U.S. economy along with the decline in the global economies.  And even if the energy complex as well as other commodities weakens, we think the stock market will continue down until it reaches reasonable valuations."  Commodities peaked in early July and the stock market declined along with commodities (A CRB chart and the charts of some commodities by the Chart Store are attached.)  

Now, for the first time in many years there is some change in the way we are thinking about the stock market. We are in the 8^th year of a secular bear market and the market has plunged since the October 2007 peak.  At today's close of 873 the S&P 500 is selling at 13.2 times 2008 trendline reported earnings, the lowest P/E ratio since 1987, and below the long-term average of about 15.  The average low trendline P/E ratio of bear markets associated with economic recessions is 10.4, not far below the 11.2 reached at the 741 S&P low on November 21.  Therefore it is possible-though not probable-that the bear market low was made on that date. 

There are two major reasons we think the market can bottom at significantly lower levels well into 2009.  First, in 5 of the last 10 bear markets connected with recessions the P/E ratio bottomed at 8 or under.  We think that this is a strong possibility this time as a result of the severe nature of the current global credit crisis and recession and the likelihood that this is a secular bear market.  A P/E ratio of 8 on next year's trendline S&P 500 earnings of $70 would bring the index down to the vicinity of 560. Second, stocks have tended to bottom about 5 months before the economy, and we would be surprised if the economy bottomed 5 months from now.  Therefore if the economic bottom was pushed out beyond the 2^nd quarter of 2009, the market probably would not trough until well into the year.

Having said that, however, the market is now somewhat undervalued for the first time in many years.  In previous years we believed correctly that the market was highly overvalued and that the economy vulnerable to a sharp contraction.  We therefore had two major factors indicating a highly risky market.  Now the market is much cheaper, but we still think the credit crisis is ongoing and that the economy is contracting at an alarming rate.  The market is thereby subject to a tug of war between a more reasonable valuation on the one hand and the prospect of a long and deep recession on the other.  In addition if the market bottom eventually occurs well into 2009 as we believe, a bear market rally is a strong possibility between now and then.  Therefore, although we believe the market lows are still ahead us, the road to the bottom is likely to be choppy and highly volatile, ending finally in a massive capitulation on the downside.   

To say that the market is closer to a bottom than a top is true by definition, but essentially irrelevant.  The S&P 500 topped at 1553 in March 2000, at 1576 in October 2007, and is now at 845.  The key question, though, is the level and timing of the eventual bottom.  Although we don't know the answer, history provides us with some rough guidelines that indicate some of the possibilities.

 In the table below the first column shows the date of all post-World War II market lows that were accompanied by recessions.  The second column marks the date of the associated economic cycle low as determined by the National Bureau of Economic Research.  The third column indicates the number of months by which the market low preceded the economic low.  The fourth column shows the price-earnings ratio on smoothed "reported" (GAAP) S&P 500 earnings at the market low. 

		Lead Time
Market Low	Cycle Low	Months	P/E Ratio
6/1949	10/1949	-4	6.3
9/1953	5/1954	-8	8.0
10/1957	5/1958	-7	12.3
10/1960	2/1961	-4	15.4
5/1970	11/1970	-6	11.0
12/1974	3/1975	-3	7.4
3/1980	7/1980	-4	7.0
8/1982	11/1982	-3	7.1
10/1990	3/1991	-5	14.1
10/2002	11/2001	+11	15.5
Average		4.9	10.4
Median		4.0	9.5

The above table enables us to make some useful observations.  First, in 9 out of 10 instances the market bottomed before the economy, and by an average of 4.9 months (say 5 months with rounding). On 6 of these occasions the market bottomed from 3-to-5 months before the economy.  Our conclusion here is that the market usually bottoms during a recession, but not too long before the end.

Second, the average P/E ratio at market bottoms was 10.4 with the median at 9.5 (we'll round this off at 10).  We note, too, that in 5 of the 10 observations, the P/E bottomed in single digits ranging from 6.3-to-8.0.  In the other 5 instances the P/E troughed in double digits between 11.0 and 15.5. 

Third, while the trough P/Es cover a wide range of 6.3-to-15.5, a closer inspection of the data provides some hints as to whether an eventual P/E will bottom in single or double digits.  For this purpose we note that a secular bear market ended in 1949 with the subsequent secular bull market lasting until 1966.  The market then remained in a secular bear market through 1982, followed by a bull market from there until 2000, when the current secular bear market started.  Since secular bear markets comprise periods where P/E ratios are declining while secular bull markets are periods where P/E ratios are expanding, it is logical to assume that cyclical P/E ratios are low at the end of secular bear markets and the first few years of bull markets.  In contrast, cyclical P/E ratios are high in the last few years of bull markets and at the beginning of bear markets.  It is not a stretch to say that this is exactly what our data shows. 

Given the above observations, what can we guess about the timing and level of the of the market bottom?  In terms of timing, we believe that the current recession will be long and deep as result of the massive credit problems, the deleveraging of the economy, the rapid drop in the numbers and the global nature of the decline.  Therefore, unless one believes that this is merely a garden-variety recession that bottoms as early as the 2^nd quarter of 2009, it is unlikely that a market trough has been reached currently.  While no one knows when the economy will bottom, any trough that goes beyond the 2^nd quarter means that an eventual market bottom will be pushed off until well into 2009.

As for levels, we believe that the secular bear market is now in its 8^th year, meaning that the P/E ratio is more likely to end in the bottom of its historical range than the top. Therefore a final low P/E ratio of about 8 on smoothed earnings is not far fetched.

Taking all of the above into account, where are we now?  At today's S&P 500 close of 845, the market is at 12.8 times our trailing smoothed reported earnings of $66.  That is nothing to sneeze at since it's the lowest P/E seen since the 1987 crash, and is also under the long-term average of about 15. It is also a vast improvement over the P/E ratio of 37 at the 2000 high and a P/E of 24 at the October 2007 peak.  Therefore, predicting a lower P/E from this point is no longer the layup it was at far higher levels.  However, we note that in 5 of the 10 data points in the table the P/E bottomed at 8 or less, and that would entail a big decline, even from this point.  In addition those occurred either during secular bear markets such as the one we are in now or early in secular bull markets when investors did not yet recognize the new uptrend.  It also noteworthy that in 24 of the 38 years preceding 1987, the market sold at lower than the current P/E at some point during the year

So far the low for the current bear market was 741 on November 21 when the P/E ratio would have been 11.2.  That is close enough to the long-term average of 10.4 at bottoms to raise the possibility that it could have been the final low.  However there is still a real risk that the eventual P/E ratio could drop as low as 8 times smoothed 2009 earnings of about $70, resulting in an S&P 500 index of about 560.  Since that constitutes another 33% decline from current levels, it is not a risk that can be easily dismissed.  We also note that our assumption of $70 in trendline earnings is a generous number since S&P now estimates 2009 reported earnings at only $49.  All in all, although we think there is some possibility that the market has already bottomed, it is more likely that the market decline still has quite a bit further to go.