I was strolling about San Francisco on Saturday, and as my eyes roamed among the sundresses, tank tops, and shorts, an idea occurred to me that might noticeably lessen the global food crisis that we've been reading so much about. Maybe Americans should eat a bit less.

It's one thing for lean and wiry third world types to complain about food prices, but quite another for those who could clearly do just fine with 90% or less of their current calorie intake. And of course by shedding some weight they would also reduce their "carbon footprint".

As I walked along a stretch of a Cable Car route, I was struck by how much loose flesh I saw jingling around this otherwise fine spring day...

Which brings us to an interesting question about the whole commodities boom - grains, energy, metals - at what point do we start to see demand destruction?

How high do gasoline prices have to go before gasoline consumption drops off (via switching to more fuel efficient cars or just driving less)? How high do food prices have to go before people in the developed world consider eating less, as much for their financial well-being as for the more general health of themselves or the planet? (According to one report I read recently, meat prices in the US have been kept low by herd culling. When that runs its course, beef, poultry, and pork prices will move more in line with feed costs.)

An article in Thursday's WSJ discussed how "relentless increases in the price of steel are halting or slowing major construction projects world-wide and investments in shipbuilding and oil-and-gas exploration". In other words, in response to rising steel prices, demand destruction is occurring at the margin.

With the price of West Texas Intermediate Crude at $126 a barrel, up 97% from a year ago, what is the "uncle" point at which demand falls enough that price itself begins to ease? $130? $150? $200?

I'm just wondering...

So, is the worst of the credit crisis over? Is the US economy going to skirt recession? Will the bifurcation of global economic performance (weakening in the US and Europe, but continued strength in most emerging markets) continue? Will high food and energy costs squeeze consumer spending enough that they will prove to be more deflationary than inflationary? Or could rising food and energy costs tip "the consumer" into an inflationary psychology that becomes self-reinforcing? (The WSJ had an article about a week ago recommending that consumers "stock up" on food items. If everyone does this, then there will be food shortages and even higher prices.) Or does the recent press fever about agflation and global food shortages portend that agricultural commodities are in for a steep correction - easing, if only temporarily, concerns about food inflation?

The S&P 500 is up over 12% from the March lows, perhaps looking out towards a recovery. But then if things are looking up, why is the TED spread still at a very high 126 bps? Why is the 3 month LIBOR 77 bps over the Fed funds rate (a year ago the spread was 11 bps)?

Have the Fed and the politicians "done enough" to ensure the weakness in the housing market does not accelerate as more homes go into foreclosure? Does the recent data suggesting that the US economy might be less weak than some thought, especially vis a vis Europe, mean that the US dollar has put in a significant intermediate term low? By the law of contrary headlines, does the fact that Congressional Republicans have called for hearings on the dollar's decline provide further evidence of a significant dollar rally? Is the bull market in gold over?...

In June of 2007 I wrote that "rising food prices is the greatest risk right now to a benign inflation outlook, and food shortages and food inflation could well be a global secular trend over the coming years."

Then came the credit crisis and the food story got buried under an avalanche of acronyms like CDS, CDOs, CLOs, SIVs, RMBS, ABCP... Well now it's back on the front page.

When Mrs. Watanabe wanted to buy butter to bake a cake, the shelves at her local Tokyo supermarket were bare.

And some scattered stories of "food rationing lite" are turning up on the East Coast and in California.

The problem is serious and long term and is finally starting to get the attention it merits.

Let's check in on the TED spread to see how much anxiety remains in the financial system -



With a spread of 153 bps, there is still a lot of fear and dread.

The graphic below of Total Borrowings from Federal Reserve Banks (from the April 11th edition of the St. Louis Fed's weekly U.S. Financial Data) also depicts the considerable strain in the financial system -



GE's earnings miss on Friday has received a lot of press, and the headline story is that if a conglomerate like GE, with global exposure, is feeling the hurt, well then things must be really bad. Considering that 1/3 of GE's profit comes from "financial services", the poor result really isn't that shocking. And there were pockets of strength in GE's report - notably infrastructure and energy.

Just to be clear, however, since early January I've been convinced that the US economy is in recession.

The current background memes are not positive - falling home prices, job losses, consumer and bank balance sheets that will take time to repair, high food and energy costs, the risk of global food crises, an increase in protectionism and export restrictions with the risk of a broader decrease in global trade...

The bullish scenario for the stock market rests on a "second half recovery". Those of us around in 2001 can recall the same talk early that year. But the current problems are much more serious and the risks greater. Last week the IMF estimated the probability of a global recession at 25% (page 31 of the report).

Good News and Bad News

First, some of the good news: the stress in the financial system has eased considerably since the last post. Using the TED spread as our proxy, you can see below that the spread has fallen from over 200 bps a couple of weeks ago to 132 bps as of Wednesday.




And the stock market has been rebounding strongly from its mid March lows. About 63% of stocks trading on the NYSE are currently above their 50 dma, the highest percentage since October of last year. As faith in the financial sytem has been restored -at least for the time being - gold has fallen by over 15% peak to trough.(Despite its sharp correction, as of Wednesday's close, gold was still more than 16% above its 69 week ema. And while the fear of a global meltdown accelerated gold's move to the upside, negative real interest rates should provide support for another move up before all this is over.) And the 3 month T-bill rate has climbed back to 1.36% after falling below .6% on March 19th.

The bad news is that things are still far from normal. Bernanke's statement to the Joint Economic Committee is worth a read. Here's an excerpt -

Although our recent actions appear to have helped stabilize the situation somewhat, financial markets remain under considerable stress. Pressures in short-term bank funding markets, which had abated somewhat beginning late last year, have increased once again. Many lenders have been reluctant to provide credit to counterparties, especially leveraged investors, and have increased the amount of collateral they require to back short-term security financing agreements. To meet those demands, investors have reduced their leverage and liquidated holdings of securities, putting further downward pressure on security prices.

Credit availability has also been restricted because some large financial institutions, including some commercial and investment banks and the government-sponsored enterprises (GSEs), have reported substantial losses and writedowns, reducing their available capital. Several of these firms have been able to raise fresh capital to offset at least some of those losses, and others are in the process of doing so. However, financial institutions’ balance sheets have also expanded, as banks and other institutions have taken on their balance sheets various assets that can no longer be financed on a standalone basis. Thus, the capacity and willingness of some large institutions to extend new credit remains limited.

Bernanke went on to mention some of the economic drags of late - a soft labor market, weakening growth in disposable personal income, declining home values, tighter credit conditions, and increased caution among business leaders...

There is so much going on from day to day that it's very hard to keep up. I think of Alvin Toffler's concept of "future shock" - a personal perception of too much change in too short a period of time.

Let's start by reviewing the actions taken by the Federal Reserve to relieve the current financial crisis which more and more people are saying is the worst in their lifetime.

1) Lowered the Fed funds rate by 300 basis points to 2.25%

2) Lowered the discount rate 375 bps to 2.5%

3) Initiated the Term Auction Facility, then a new Term Securities Lending Facility which allows schedule 2 collateral including CMOs and top rated CMBS, established a Primary Dealer Credit Facility to provide funding to Primary Dealers (such as Goldman or Lehman, rather than just depository institutions). As (at least) one person has noted, the Fed has become the counterparty of last resort.

4) Provided a $30 billion backstop for JP Morgan's takeover of Bear Stearns.

But strains of various sorts persist in the credit markets. As of Friday March 20th, 3 month T-bills were yielding .63%, the lowest since 1947, indicating the panicky nature of the latest "flight to quality". The TED spread, a classic gauge of stress in the financial sytem, is now above 200 bps, after averaging 38 bps during the first half of 2007. A tiny, non-clickable chart is below -



And as of Thursday March 19, the ratio of yields on Moody's Seasoned Baa to Aaa is at a 45 year high (the data set starts in 1962).

And then there are the Commercial Mortgage Backed Securities (CMBS) mentioned in a prior post and written about in this weekend's WSJ. According to the WSJ article, these securities are currently priced for default rates of 80% or more, though the worst period for commercial real estate debt saw default rates no greater than around 31%.

The US dollar index has probably begun a countertrend rally that will zig and zag higher over the next few weeks or months. At the same time, commodities and commodity related stocks have pulled back sharply, with the CRB index down 6.75% on the week, and the Morgan Stanley Commodity Related Equity index (CRX) down 8.6%. Some of this was likely sector rotation from stocks that were extreme overbought (commodity related) to those that were extreme oversold (financials - the BKX was up 11.5% for the week). But as noted in a prior post, a larger than usual share of the commodity surge from mid February on was due to the sharp decline in the dollar.

Yeeehaaa!

At least for a while. The fact is that over the past 6 trading sessions, the stock market has had two huge up days (we'll use the S&P 500 as our proxy) of 3.7% and 4.2%. On Tuesday, even the credit markets responded and spreads narrowed.

So when was the last time the S&P 500 rallied more than 3.5% on two separate trading days within a 6 td window? On October 11, 2002 the S&P rallied 3.9%, and on October 15 it rallied 4.7%. Other times when this happened were July 2002, September 1998, October 1987 (after the Crash), August 1982 (the beginning of the mega-bull market), and October 1974. With the exception of the 1987 post-crash snap back, all of these occasions marked the beginning (at the least) of very tradeable rallies.

The macro problems haven't gone away and we're still in Imelda's closet, so more shoes can start dropping anytime. I think we're still in a bear market with more downside ahead. But for now I've got my rally cap on.

I'll Give You Two Bucks

Done!

I'm speechless. What this means is that the problems at BSC were deeper than just about anyone thought. According to the options column in this weekend's Barron's, the March 12.5 to 7.5 put spread implied a 10% chance of BSC trading below $10 a share before this week's expiration. Book value of $80 a share? Um, no.

Who else is in trouble? Nobody wants to find out. As I write this, overseas markets are being pummeled and S&P 500 futures are down nearly 3%. The Fed is trying to "reassure" markets by lowering the discount rate 25 bps, but we may have reached the point where the more the Fed does, the more markets panic.

It looks like Monday would be a good day for the legendary Plunge Protection Team to make an appearance. That is, unless they are having trouble meeting their margin call.

As we said last week, risk aversion in the credit markets remains high despite the efforts of the Fed. Just ask Bear Stearns.

The chart below shows the sharp increase in risk spreads among some A rated commercial mortgage backed securities -



Is the doom and gloom regarding commercial real estate justified? Well, at this point I would be reluctant to believe anyone who says "fears are overblown". And the extreme risk aversion shown by banks desperate to shore up their balance sheets can become self-fulfilling prophecies of sorts. At this point noone wants to be left holding the bag. Again, just ask Bear Stearns.


We would seem to be coming up to a critical juncture where either, in the words of WB Yeats, "things fall apart; the centre cannot hold... the blood dimmed tide is loosed...", or, where the centre does hold (or at least the recent lows on the major stock indexes hold) and the "blood dimmed tide" is held back for a bit longer, if only by a finger in the dike. Imagine Ben Bernanke as the little Dutch boy.

The massive rally this past Tuesday gave an inclination of just what can happen when an oversold market thinks that the worst may have passed. With the latest Investor's Intelligence weekly sentiment survey showing the lowest percentage of bulls (31.1%) and highest percentage of bears (43.6%) since October 2002, pessimism is so high that any bit of seeming "good news" can ignite an orgy of short covering and lure some of that sidelined cash (earning rates of return well below that of inflation) back into play. The current financial crisis is systemic, however, which means that the "Imelda Marcos effect" (a virtually limitless number of shoes to fall) still holds. What we can say for sure is what we said many months ago. Savers will continue to get screwed. And as the dollar depreciates and commodity prices rise in the current macro climate of falling home prices and tight money, the less affluent will be squeezed tight by declining collateral values, more restricted access to credit, a weakening job market, and a higher percentage of income going to necessities.


For a long time I respected the interest rate markets assessment that the Fed was behind the curve and should be reducing interest rates. But now I think the Fed risks going too far and may do more harm than good. Since the middle of February the US Dollar Index has been falling off a cliff. The dollar's drop has accounted for a good part of the rise in many commodities since mid February, as you can see from the charts of the CRB, the first in dollars, the second in Euros -








For decades the Armageddon scenario of the uber bears has been that of a global flight out of the dollar where stocks fall and bond yields rise as dollars get passed around the globe like so many hot potatoes. When the Fed is left with the choice of slashing rates below the rate of even "core" inflation, or disappointing market participants with a measly 50 bps as solvency issues are pushed to the forefront, one wonders if maybe that scenario could actually happen. Even if it doesn't, the combination of a perception of ineffective monetary policy accomodation and rising inflation expectations would be bad enough in itself.

Risk aversion in the credit markets remains very high despite the efforts of the Federal Reserve. A recent example is that the survival of Thornburg Mortgage has been called into question despite the fact that their portfolio of mortgages has been performing well. Standard and Poor's said the credit quality of Thornburg's mortgage portfolio remained "extremely sound". Thornburg's CEO complained "the panic that has gripped the mortgage financing market is irrational and has no basis in investment reality". An analyst at JPMorgan Chase has called the most recent convulsions a "systemic margin call".

Whether or not the latest panic has any "basis in investment reality" cannot yet be known. On a percentage basis, the spread between the Moody's AAA and Baa corporate bond yields is the highest since 1982. (Data from the St.Louis Fed can be viewed and downloaded here.) The Treasury-Eurodollar spread has widened to a 2 month high of 167 basis points. Interest rate futures markets have priced in a 1.75% Fed funds rate by August. The question is whether we are close to a capitulation of sorts or whether credit markets are at a deeper recognition stage of just how serious things really are. What's worrisome is the Sorosian law of reflexivity applies on the way down as well as on the way up. Financial markets can influence the events they attempt to predict, so a continued contraction in credit would make the recession worse than it would be otherwise.

If credit markets don't heal a bit this upcoming week, I think commodities are in for a nasty correction. They may correct anyway. Below is a weekly chart of the CRB index. The reversal pattern on a weekly chart isn't to be taken lightly.

Whether you view the stock market as undervalued, overvalued, or just about right depends largely on your view of earnings estimates and inflation. The most recent "as reported" earnings estimate from Standard and Poor's for the S&P 500 for 2008 is $71.20. So based on Friday's close of 1330.63, the S&P is currently trading at 18.7 X estimated earnings. With the 10 year Treasury yielding 3.53%, the stock market is undervalued... right? I mean the earnings yield on the S&P 500 is over 5%!


Before you put on your Yeeehaaa! hats in anticipation of a melt up to 2000 on the S&P 500, consider this: I read recently that consensus earnings estimates have not forecast a decline in earnings in 20 years, yet in recessions since 1970 the average decline in global earnings has been about 30%. So if there is a recession (I think we are in one), the current earnings forecasts are most likely useless for attempting to value the market.

Another point to consider is that since 1953, the yoy % change in the CPI has been below that of the yield on the 10 year Treasury note (monthly basis) about 90% of the time. Yet we have now had 3 straight months where the yoy % change in the CPI has risen above the yield on the 10 year note. So, when was the last time this happened? November 1978. And before then? November 1973.

Funny how this weekend's WSJ had an article about how polyester is making a comeback.

So it would seem that either inflation eases or bond yields rise. As far as the stock market is concerned, according to research by Goldman Sachs, from 1950-2006 periods where inflation has averaged less than 2.5% have coincided with the most generous PE multiples (18.6X), and those where inflation has been greater than 7.5% the lowest (8.6X).

BCA Research insists concerns about inflation are misplaced. With all the bad debt out there, of course there are strong deflationary (or at least disinflationary) forces at work. But so far commodity prices seem unaffected. Even the Baltic Dry Index has been working its way higher since late January.

A quick scan of the recent economic headlines at Haver shows that the news backdrop continues to be negative. The Chicago PMI is the lowest since 2001, home price appreciation is the weakest since 1990, and the 3 month annualized growth rate in inflation-adjusted disposable income is at -.7%. (And that's just the news out of the US) On Thursday, Rasmussen's index of consumer confidence hit its lowest level in 7 years.

Lots of bad news has been priced in via the interest rate futures markets (another 125 basis points worth of cuts in the Fed funds rate by October of this year), but the stock market just doesn't seem to have yet discounted enough bad news to avoid reacting with shock and dismay to news suggesting such future actions may actually be justified.

As I've mentioned many times in the past, one of the major issues facing the world is rising food prices . The chart below shows the yoy % change in the food component of the CPI -




The less well off you are, the higher a percentage of your income goes to food. The article linked to above focuses on poorer countries, but the poor in the developed nations are being hurt as well. The degree to which high food and energy prices filter through to core inflation may remain limited, but as the consumer spends a higher percentage of his/her income on necessities, the effect on the larger economy will be contractionary.

To continue with a theme from a recent post, below is a weekly chart of the ratio of the CRB index to the S&P 500. You can see that since early October commodities have been dramatically outperforming the S&P 500.



In fact the ratio is now close to its highest level reached in the last 5 years.

I'm not sure what to make of this. We have a US economy that is in or very close to recession and slowing economic activity in the Euro area and Japan. The violence with which global markets sold off in response to credit fears seemed to demolish the thesis that the rest of the world could keep growing nicely even if the US fell into recession. And yet the strength of commodity prices raises the possibility that fears of a deep US recession are overblown, or that the decoupling scenario is back in play. Take a look at a weekly chart of copper prices -



Copper has been in a consolidation pattern since reaching its high in the first half of 2006. It looks just as likely to break out above its 2 year range as it does to break down below it.

In a Reuters story on Rio Tinto seeking a steeper price hike for its iron ore than that obtained by Brazilian rival Vale, RTP's CEO was quoted as saying -

We're in an environment of strong markets and we can afford to be patient...We certainly see the demand continuing to be strong and we don't see anything in the medium term to change that...The drivers for global demand are certainly more than offsetting the effects of softer consumer demand in the United States.

Sounds like decoupling to me.

The current issue of Barron's has an article titled "It's Time to Nibble on Junk-Bond Funds". According to the article the average junk-bond is yielding 7.28 percentage points over Treasuries with comparable maturities. Two high yield bond fund managers are quoted who say that risk is being fairly compensated by current yields.

What's a bit odd however, is that current default rates are still extremely low (1.1% at the end of January), and as BCA Research notes, bond spreads don't usually peak before the cyclical rise in defaults even gets started. (Default rates troughed in November 2007 at less than 1%.)

Moody's is forecasting speculative-grade default rates to rise to 4.8% by the end of 2008. The forecast does not assume a US recession, however. In the event of a US recession, Moody's allows that default rates could reach 10% as they have in previous recessions.

The chart below shows the relative performance of the CRX (commodity related stock index) to the Wilshire 5000 -



On a monthly closing basis, the CRX has outperformed the Wilshire 5000 in 68 out of the last 96 months - 71% of the time.

So how is "the consumer" doing? Well, we all know the story with housing, and we know that consumer loans are harder to come by, and that job growth turned negative last month, but how about inflation adjusted hourly compensation? How's that doing?




Where's the consumer going to get his/her buying power?

The NFIB's Index of Small Business Optimism fell in January to its lowest level since 1991. At the same time, 8% percent of respondents cited inflation as their number one concern, the highest level since the 1980s. And once again, there are no indications that the "credit crunch" has impacted the small business sector: only 4% of owners cited credit cost and availability as their number one problem.

The Rasmussen Consumer Index also hit a new 5 year low on Tuesday.

As for the stock market, I'm operating under two assumptions. The first is that we are now in a bear market so that the general trend is down, and the second is that the January lows will hold for a while.

The stock market keeps getting flat-footed by bad news. Unless there was a major data glitch in the ISM report for the non-manufacturing sector, I think it's very safe to say that the US is now in recession. What's surprising is how shocked the stock market seemed by this latest bit of evidence. It's not like it came out of the blue. The ECRI's weekly leading index, for example, just tagged its six year low.

On the one hand, almost everyone has been expecting the Fed to slash short term rates this year. On the other hand, few seem prepared for the kind of economic data that would justify such action. Those who think the rate cuts have been primarily in response to or for the benefit of financial markets are missing a good part of the picture. Economic data has been weak, and as I said recently, the Fed's efforts notwithstanding, the macro background is one of tight money. This is where things could get ugly. Without credit, neither business nor "the consumer" is going to be able to spend their way out of this recession.

The charts included in the latest Senior Loan Officer's Survey from the Federal Reserve provide an excellent graphic representation of how this recession may be different from the last two. As the Fed lowers the cost of funds, credit tends to become more available, not less. So far the opposite is happening. The charts below are (as usual) clickable -












To be clear, there is not yet a credit crunch on Main Street. The charts above indicate a tightening of standards and an increase in risk aversion. According to the ISM services report mentioned earlier, when respondents were asked , Is the turmoil in financial markets having any effect on your firm's ability to obtain regular or additional financing?, 85.4% answered "No".

Some charts we've seen before now show reflation bets are coming back into the stock market.

First, from the chart of the ratio of the price of the long Treasury bond to the S&P 500 you can see that this ratio has started to move back towards its longer term moving average.



Next, the bank index continues to exhibit strength against the broader market.



And cyclicals are outperforming as well.



Small caps have been doing better than large caps,



Value stocks are doing well versus growth stocks.




Even consumer discretionary stocks have caught a bid.




The question is whether all this is just a retracement towards longer term moving averages after a period of extreme deviation from them, or something a bit more. One encouraging technical sign that the current stock market rally may have some legs is that the closing tick on the NYSE has been over 1000 for 2 of the last 4 days - something that hasn't happened since the beginning of last July.

Friday's report on employment and the ISM Manufacturing numbers will give a better indication of whether the Fed has caught up with the curve... or not. That perception will determine the short term fate of the reflation trades.

For a while Wednesday it looked like the stock market might have one of its "Yeeehaaa!" days. The Fed delivered the 50 bps the market wanted and things were looking good for the longs with the Dow up 200 points. The good news was that it seemed like the Fed was no longer behind the curve. The bad news was that the rating agencies also had been behind the curve and they too had some catching up to do. So when the news crossed the wires that the world's 4th largest bond insurer (Financial Guaranty Insurance Co) lost its AAA rating at Fitch, that took care of the market's little party. The 5 minute chart of the Dow tells the story.



Then S&P said it may reduce ratings on $534 billion on sub-prime paper and CDOs. As some wise guy quipped a while back, the shoes keep dropping like you're inside Imelda Marcos' closet.

So the tug of war between the reflationary efforts of the Fed and the deflationary effects of the credit implosion goes on. I know some are very confident about the ultimate outcome ("a brief mild recession", "a protracted global depression") but I'm not one of them. But I'm confident that the US is now in recession and that it's going to get worse before it gets better. As banks rebuild their balance sheets, credit conditions will remain tight and consumers will be forced to retrench. How the cross currents of a weakening economy and a general labor shortage resolve could be a key factor in determining the length and severity of the recession. The FOMC statement was somber -

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

One of the big themes of late has been food inflation. I've talked about this in many previous posts, but it's global in nature* and is not going away anytime soon.

On Monday Tyson Foods filed their 8-K. Below is an excerpt (emphasis mine)-

“In November, we projected an additional $300 million in grain costs for fiscal 2008,” Bond said. “We now think this year-over-year increase will exceed half a billion dollars. Because of these unanticipated and extraordinarily high corn and soybean meal costs, we have no choice but to raise prices substantially.

“The continued escalation of grain prices, driven largely by government mandates for corn-based ethanol, has caused a domino effect for other inputs. Cooking oil, flour and other feed ingredients are all on the rise. For the foreseeable future, consumers will pay more and more for food, especially protein, because grain represents a proportionally higher percentage of input costs compared to other foods.

“The commodity markets affecting our business are extremely volatile and fluctuating tremendously on a daily basis. For this reason, we have decided to temporarily withdraw our previously issued earnings guidance. In this erratic and unpredictable operating environment, it is virtually impossible to make meaningful earnings forecast assumptions.

Upcoming Fed Decision
Fed funds futures are pricing in a 90% probability of another 50 basis point cut at Wednesday's FOMC announcement. Right now I'm leaning towards 25 bps myself, but Tuesday's report on durable goods orders will tilt the balance one way or the other. (The consensus is for a 1.6% rise.)


* For fun I just did a Google news search for "food inflation" and found recent stories on the topic pertaining to Indonesia, India, France, Great Britain, Trinidad and Tobago (where food inflation slowed to 16.8% yoy), China, Australia, Peru, and the US.

Let's look at a few charts to see where we are right now.

The Wilshire 5000 is set for a monthly close below its 20 month moving average for the first time since 2003. As mentioned several times before, since 1995 the 20 month moving average has been the bull/bear line in the sand.



But already there seem to be some reflation bets coming into the market, as you can see from the ratio of the Morgan Stanley Cyclicals Index to the Wilshire 5000. After underperforming the broader market since July, the cyclicals have been outperforming for the last two weeks. How long can this last?



The Bank Index has been outperforming the S&P 500 over the past couple of weeks as well. Is this just a retracement, or has the banking sector put the worst behind it?



In any event, gold continues to do very well -



As of Friday the yield on the 2 year T-note was 2.19%, the yield on the 10 year note was 3.56%, and the year over year percent change in the CPI from December 2006-December 2007 was 4.1%. Negative real rates are positive for gold. (This fact is frequently misstated as "gold is an inflation hedge".)

Gold continues to rise against the Euro, Canadian dollar, British Pound, Swiss Franc, and Japanese Yen as well.


Follow up

In a prior post I referred to the massive sell-off in agricultural related stocks that began January 15. On Thursday January 24, Potash Corporation released its 8-K. Here's an excerpt (the emphasis is mine) -


The growth in global population and strengthening of world economies that is driving demand for agricultural products and fertilizers is expected to continue. China has seen strong increases in its gross domestic product annually for over 15 years and double-digit growth in the past five, while India, Southeast Asia, Brazil and Latin America have more recently been experiencing excellent economic growth. An increasing number of people in these areas now have the money and the desire for a higher standard of living, and are developing appetites for the protein-rich diets that westerners have enjoyed for decades. Rather than leveling off, this trend is gaining momentum. The world has been enjoying unsustainably low grain prices for many years by drawing down inventories. Grain consumption has exceeded production in seven of the past eight years (and the USDA 2007/08 crop year forecast is expected to extend this further), so this decline in grain stocks began before biofuels became much of an additional draw on global crop production. The world’s wheat and coarse grains stocks-to-use ratio is at a record low after being adjusted downward again in January 2008 to 14.1 percent, just a 1.7-month supply. This is resulting in further significant increases in crop prices around the world. With agricultural land declining on a per capita basis, farmers are working to improve yields to meet rising global food demand.

With rising prices for crops and crop nutrients, $1 invested in appropriate fertilization can generate approximately a $3 return through higher yields. Expectations for this type of return can vary depending on many factors such as type of crop, climate, soil quality or access to water. For some crops, such as Brazilian sugar cane and Malaysian oil palm, the payback — with current crop and fertilizer prices — is typically much greater than the 3 to 1 relationship. This environment makes the economics of the fertilizer business, especially potash, very attractive. For a US corn farmer, average farmgate corn prices have increased by $2.00 per bushel over the past two years, which roughly translates into a $300-per-acre boost in farm returns on a yield of 150 bushels/acre. By comparison, a $100-per-short-ton increase in North American potash prices adds only $0.03 per bushel, or $4.50 per acre, to the cost of producing corn. A similar economic model exists for soybeans and wheat. This relative inelasticity to price leaves demand undamaged, even in the face of fertilizer price increases.

If you're not yet sick to death of hearing opinions on this past Tuesday's emergency rate cut from the FOMC, you could do much worse than to read Professor Stephen Cechetti's brief analysis.

The immediacy of the cut has its genesis in both the deterioration of macroeconomic conditions over the last week ending 18 January 2007 and the possible desire of Chairman Bernanke and his colleagues to change the Committee’s modus operandi.

Starting with the data, since the beginning of the month we have seen a very poor employment report (released on the 4 January), evidence of a fall in real retail sales (15 January), information that industrial production was unchanged in December (16 January), and confirmation of a continued precipitous decline in residential construction (17 January). Taken together, this all suggests that the US economy may already be in a recession. My own guess is that the peak in the business cycle was November 2007 and that the economy is currently shrinking, albeit modestly for now.

...Chairman Bernanke and his colleagues want us to know that when they see changes in the economy that compromise their medium-term stabilization objectives, they will act. They will do what needs to be done and they will do it right away.

To the list of data mentioned above, I would add the plunge in consumer confidence (based on Rasmussen's daily poll) and a much weaker than expected report in the Philadelphia Fed's Business Outlook Survey (which is what made me think an intermeeting cut was more than a pipe dream).

You can't help but wonder how Tuesday would have gone without the 3/4 point rate cut. I mean, think about it - after the largest rate cut since the 1980s, the Dow still closed down 128 points, breadth on both the NYSE and Nasdaq was negative, and the closing Tick was -223.

Wednesday's another day and the stock market could well be sold out, but I think Tuesday's negative close is strange and a bit ominous - even if we rally for a while.

One necessary element is in place for a move higher. The BKX (Bank index) has been outperforming the S&P 500 on a relative basis for over a week, and the momentum has turned positive. It's a start...




Something to keep in mind is that if we are now in a bear market (as many, including your humble pajama clad blogger, believe we are) the "oversold" readings on any number of indicators are not to be interpreted as they were during a bull market. Whether its crowd sentiment readings, bullish percent indicators, percent of stocks below 50 or 200 day moving averages, etc, the context in which these indicators are to be interpreted has changed.

So, did they panic, or are they simply trying to catch up with, if not get ahead of, the curve?


The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3-1/2 percent.

The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Eric S. Rosengren; and Kevin M. Warsh. Voting against was William Poole, who did not believe that current conditions justified policy action before the regularly scheduled meeting next week. Absent and not voting was Frederic S. Mishkin.

In a related action, the Board of Governors approved a 75-basis-point decrease in the discount rate to 4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Chicago and Minneapolis.

I think a 75 basis point cut has happened only once before (in the 1980s), and never in the interim between scheduled FOMC meetings.

Some Themes and Memes

A few bullish themes and memes -

- according to the Fed model the S&P 500 is 40- 50% undervalued

- insider activity has been more bullish than bearish

- the recession, if there is one, will be brief and shallow because it would be starting with a very low inventory to sales ratio, real interest rates are already negative, and, with a general shortage of skilled labor, companies will be very reluctant to lay off productive workers.

- it's an election year, and the politicians will do everything they can to provide fiscal stimulus.

- while stock and corporate bond prices may fall further, there are strong hands out there (think Sovereign Wealth Funds) with plenty of cash. Assets will move from weak hands (panicky individual investors, funds and prop desks forced to liquidate portfolios) to strong.

Now the bearish ones -

- what we are experiencing now is the deflating of a credit bubble. The deflation of bubbles takes time, and this will be no exception.

- we are in a consumer led recession that is just getting started. People are late with their mortgage payments, their credit card payments, with their phone bill payments for Chrissakes!

- the Fed may be lowering administered rates, but to rebuild their balance sheets banks are restricting credit. It's fair to say that the macro environment is one of "tight money" and that it will stay that way for some time.

- earnings projections will be revised down, first for 2008, then for 2009 as the second half recovery fantasy bites the dust. The current forward earnings yield input to the Fed model is way overstated, rendering the output ("the stock market is way undervalued") useless.

- there will continue to be deleveraging for some time to come, some of it forced. We got a glimpse of how ugly this can get last summer when some hedge funds and prop desks liquidated stock portfolios in response to losses in credit markets. As a consequence, multiples may continue to contract despite downward revisions of forecasted earnings and low Treasury yields.

Both the Fed's recent Beige Book report and the latest University of Michigan consumer sentiment survey might leave some with the impression that conditions are not really all that bad.

Keep in mind that "animal spirits" seem to have deteriorated very quickly. As recently as January 10, the daily Rasmussen Consumer Index was at 97.9. As of Saturday January 19 it was at 85.7 - a 12.5% drop in just 9 days.

And,according to the NY Post, "pink slips began in earnest on Wall St. last week".

The major global stock markets were unable to catch a bid this past week. The S&P 500 was down 5.4%, the Nikkei down 1.7%, the German Dax Composite down 5.2%, the French CAC 40 down 4%, the FTSE down 4.8%. On the one hand, I was surprised at the lack of any halfway credible countertrend rally. On the other hand, the market came into the week at the "recognition stage", (you know, like when Wiley Coyote goes off the edge of the cliff and suddenly looks down), so the optimists had some major portfolio adjusting to do and the shorts felt too confident to cover on anything as lame as a fiscal stimulus package.

One of the stock groups that really took a beating this week was the agricultural stocks. Here's a list of some I follow with their weekly percentage drop - CF (-17%), DE (-14.4%), MON (-12.3%), MOS (-19.3%), TNH (-11.5%), TRA (-17.2%). This group had been one of 2007's very best performers and had become overextended by any measure (MOS is still 70% above its 69 week moving average). For those who have done well with these stocks, the question is whether to write them off for a while, or start looking for buy points. I'm inclined towards the latter. The food inflation story is still very much intact, and the up cycle for agricultural commodities will be a long one. The parabolic nature of the ag stocks' move from August-January made the group vulnerable to both panicky profit taking from the momentum crowd and aggressive short selling (the group had a "long way to fall"). The group could correct quite a bit more, but in my opinion those who think the ag stocks are "done" will be proven wrong sooner rather than later.

The Philly Fed Index was lousy enough that I've joined the camp of those who think an inter meeting cut from the Fed is a distinct possibility. The report was actually stagflationary ("Indicators Suggest Weakening", "Firms Report Higher Prices", "Six-Month Outlook Weakens Further" were the headings), but the problem facing the Fed is that if it focuses on inflation it risks a severe US recession that will take the world down with it. Some think a severe recession is inevitable regardless of monetary policy, and they could be right. Meanwhile, the stock market just keeps getting surprised by the bad news.

A few stories from credit land

Moody's, S&P Reviewing Bond Insurers as Losses Mount . Needless to say the stocks of those companies affected took it on the chin Thursday.

Perini Construction (PCR) fell over 26% Thursday after a developer defaulted on a $760 million loan from Deutsche Bank AG for his Cosmopolitan Resort & Casino on the Las Vegas Strip.

BusinessWeek has an article on The Home Equity Crisis Ahead. I remember all those ads on the radio a couple years ago for home equity loans, and even alluded to them in this post from March 2005.

Based on data from the St. Louis Fed, the spread between Moody's Aaa and Baa corporates is at its highest level since January 2003, but still well below the peaks of fall 2002.

There's more, much more, but I'm out of time. There's no doubt that the news backdrop is the most depressing it's been in years. So bad that even the news on antidepressants is depressing.

This upcoming week should be interesting at the very least and has the potential to be pivotal. The economic calendar includes PPI and CPI, industrial production, the Fed's Beige Book, the Housing Market Index, consumer sentiment, and leading indicators. The earnings calendar includes Citigroup (Tuesday)and Merrill Lynch (Thursday).

Sentiment going into this week is very negative, so the markets' reaction to any perceived good news could be dramatic. I know, it's hard to imagine any good news, which sort of proves the point...

My operating hypothesis is that we are in a bear market and the August lows are going to be broken on the major indexes. I wouldn't be surprised at all, however, to see a rally this week should the general news background improve just a bit. Some technical aspects of the market are at relative extremes. I've recently noted the very low bullish percent readings for industrials and materials stocks and the extreme deviation above both long and short term moving averages of the ratio of the price of the long Treasury bond to the S&P 500. To this you can add the ratio of consumer staples to consumer discretionary stocks -



Yeah, I get it, "the consumer" is hunkering down, even those consumers who, amidst a more ebullient zeitgeist, might shop at Tiffany's. Still, the anti-consumer trade looks very crowded right now.

And, on a weekly closing basis, for the past two weeks Citigroup has been further below its 40 week moving average than at any time since October 1998. Of course that doesn't mean it can't go lower. As PIMCO's Bill Gross told Barron's, we are currently in "a unique situation the world hasn't faced in modern times." Still, there are deep pockets out there who are willing to buy and wait.