Welcome to the Bear Market... We got everything you want!

Or, depending on your point of view you could just as easily use the other lyrics “it gets worse here everyday”. Strangely enough, I would argue that both lyrics are equally true in describing this current market environment; for it is in destruction where we often find opportunity. It has been said that Benjamin Graham (the father of value investing) made a fortune buying up stocks that had been unfairly punished during the darkest days of the Great Depression. Just as history repeats itself, we are starting to find the sort of prospective investments that would make any good value fundamentalist drool in a state of bargain bliss. Although markets, just like economies, are susceptible to periods of contraction they are also inherently cyclical. The good thing about stocks is that there exists a floor of intrinsic value represented by either future earnings power or liquidation value. The trick to generating superior returns in this environment is to identify the stocks that have a strong business model and a history of consistent earnings growth which have been brought down in price along with the broader market.

Friday marked the entrance of the Dow into bear market territory when it briefly touched 20% below the record close it reached in October 2007. The Dow has been trading mostly sideways in 2008, albeit with a slight downward bias, although June has been especially rough. The data received last week was mostly mixed and most likely not the main catalyst precipitating the large decline experienced by the markets. It is my belief that it is runaway oil prices and the weak US dollar that is the invariable source of angst for Wall Street. Case in point, the Conference Board’s Consumer Index reading declined to its fifth lowest reading on record, with the economic expectations outlook portion setting a new all-time low. Both the economic expectations and job market outlook sections seem to suggest that inflationary pressures are hindering growth in the economy and are severely impacting the spending and savings decisions of consumers. Such high inflationary expectations and a bleak employment outlook can cause the American consumer to go into hibernation, dragging the entire economy down with it. Inflationary expectations must be squashed with coordinated policy efforts on the part of the Fed and the US treasury to support the dollar and bring balance to the economy. Sustaining interest rates at this level will unfortunately not improve credit and lending conditions; it will only help to maintain the current commodities rally that is responsible for pushing up inflation and dragging down economic growth.

According to James P. O’Shaughnessy’s book, What Works on Wall Street, there have been 9 periods of 10% or greater declines from peak to trough values for the S&P 500 index between Dec 31, 1962 and Dec 31, 2003. The average decline percentage and duration (in months) for this period has been 24.77 and 13.00 respectively. From where we sit today, the market is not far from the averages of either percentage decline or duration. Although I am of the opinion that the US economy is headed for an extended period of stagflation, this thesis is contingent upon policy actions (or lack thereof). So if an investor has a long-term time horizon, now is definitely an opportunity to search out undervalued opportunities - Go ahead, look for that baby thrown out with the bathwater; he’s out there!

The economic calendar is jam packed next week heading into the holiday weekend. The unemployment data and ISM index are two key indicators whose release will be closely watched so as to give some clue as to the health of the economy. I would not personally add to any positions going into this week, however I do believe that if any numbers come in to the upside this relief for traders may turn into a rally on the heels of such a prolonged decline. Volume will likely be light at the start of the week setting the stage for the market to extend it’s losses with no large buyers stepping up to the plate before the long weekend.

Welcome!

It is a remarkable time to be an observer of the financial markets.

So much has happened to both the United States and Canadian economies over the last 24 to 36 months I wouldn’t know where to begin. So instead of boring any readers with an anecdotal and undeservingly brief history lesson I will concentrate my efforts on what lies ahead. Since we are at the midpoint of the FOMC’s two day policy meeting, I believe it fitting to focus my first post on the state of the US economy. Firstly, how relevant is this meeting? A large portion of Fed observers seem to be of the same opinion that an interest rate hike could be exactly what the economy needs, however, the likelihood of this coming to fruition is extremely remote. This is in fact, in stark contrast to the treasury futures market which is pricing in the likelihood of a series of interest rate hikes, with the first round beginning by the fall meeting. It’s interesting to see how pundits’ policy expectations can change so dramatically when we can all use our short term memory to recall the cold days of winter when it seemed like the Fed was cutting rates on a daily basis and Wall Street was screaming for more. Unfortunately, these rate cuts have done little to ease the credit crunch and have arguably pumped more hot air into an already over inflated commodities bubble.

Commodity inflation, and its flow through effects on production and ultimately consumption, is ‘fueling’ the debate on interest rate increases. It is popular right now to believe that the Fed and the government should coordinate policy to prop up the lowly US dollar, thereby possibly deflating the commodities bubble and in effect helping to spur on a broader economic recovery. This type of action I believe would have a meaningful effect, however, the depreciation of the dollar has been slowly occurring over the last 5 years while the price of crude oil has jumped over 50% since the fed began its interest rate slashing. This tells me that if the dollar is truly the key to bringing down oil prices, the fed has a long way to go before we see levels even close to what we were previously accustomed to.

Unfortunately for the Fed, I believe they have lost what is possibly there strongest policy tool: Credibility. By cutting the target rate several times from 5.25% in September 2007 to the 2% level we are at today and now making the 180 degree turnaround to talk hawkish on inflation is not going to fly with anyone. The signaling effect the Fed has in its statements has the power to affect expectations; open market operations to manipulate the Fed funds rate only has an effect on the short end of the yield curve. By dramatically and systematically cutting rates, then talking tough on inflation when it appears as though they won’t back it up tomorrow, all at a time when the economy is teetering on the brink of recession shows that the Fed has lost touch with the economy. Without having the ability to sway inflationary expectations with signaling subtleties, the Fed is left only with blunt policy tools not fit for use at this stage of the game.

The economy is currently at a very sensitive state, and I believe it is jobs that hold the key to either prosperity or collapse. The media has not labeled this a recession because GDP has not actually turned negative, although those numbers may eventually end up being adjusted; but more importantly in my mind, unemployment is not yet at a point commonly associated with recessionary levels. As inflation moves through the inputs to the end users, producers and manufacturers are finding it increasingly difficult to pass on costs to an already strapped consumer. Herein lies the issue, if costs are passed on across the board, without job cuts, it is theoretically possible to see a wage-price spiral lead to out of control inflation. On the flip side, if labour is cut in an effort to trim costs, no one will be able to buy the very goods being produced (Not to mention the effects on the housing market). According to the Hoover Institution, personal consumption accounts for 70% of GDP, making the employed consumer the key to the economy. This is precisely why I am advocating for a tough stance on inflation to bring down commodity prices from such a blasphemous level and dig out any stifling inflationary expectations this market is creating. This action could lead to job market stability allowing the economy to skirt further deterioration in productivity.