The big moment has arrived – a new-look blog site for Investment Postcards from Cape Town! Since launching my international investment blog at the middle of last year, traffic has increased measurably, causing me to revamp the site.

But a fresh appearance is only one facet of the new site. Additions include features such an index ticker, stock market polls, a translator and video clips, and also sections on South Africa (where my investment management business has its headquarters) and Humor (for those moments when the weight of downmarkets becomes just a little too much to bear).

A very important change is the domain address (URL) of the blog, which is now: http://www.investmentpostcards.com. Please bookmark this address with your favorites. Also, delete any reference to the old URL (http://investmentpostcards.wordpress.com) as this post is the last one on the old site.

The principal advantage of an own domain is that it allows significantly more flexibility regarding site design, with the ultimate aim of providing readers with a compelling read in a pleasant blogging environment.

I hope you share my enthusiasm for this exciting project that has been immensely fulfilling and has enabled me to make so many new friends all around the world. Let’s raise a glass to memorable (and profitable) market moments!

See you at: http://www.investmentpostcards.com. 

The past week witnessed an extraordinary set of events on the financial front, a rogue trader creating havoc at Société Générale, and wild swings on global stock markets as mounting concerns about a recessionary US economy and the implications for global growth continued to weigh on investor sentiment.

The week started off with sharp declines on European and Asian stock markets on Monday (when the US markets were closed in commemoration of Martin Luther King). This was followed by the Fed’s emergency 75-basis-point-cut of its benchmark rate to 3.5% before the opening bell of the US markets on Tuesday, aiming to help support the troubled financial sector and stabilize the economy. The move, which came before the Central Bank’s formal meeting next week and marked the largest cut in the Fed funds rate in more than twenty years, helped prevent a larger drop in US equity prices.

Although investors’ initial reaction was lukewarm, stability returned to stock markets as they took heart from a possible rescue plan for troubled bond insurers (so-called monolines). In addition, the unveiling of a $150 billion US fiscal stimulus package by the Bush administration was viewed in a favorable light even though it was criticized just a few days earlier.

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance chart.

Economy
The Fed’s interim interest rate cut resulted in a further steepening of the yield curve with the aim of enabling shell-shocked banks to start lending again, and to start making profits so that they might be able to grow their way out of the credit crisis over time. The following chart illustrates how the yield curve has steepened since the first reduction in the Fed funds rate in August, 2007.

US YIELD CURVE

Source: StockCharts.com

As far as economic statistics are concerned, US jobless claims for the week to January 19 surprised on the downside, reflecting a situation not yet commensurate with recessionary conditions. The US housing market, however, remained mired in weakness, according to the National Association of Realtors’ report for December. Existing home sales declined by 2.2% while the median existing house price was down 6% from one year ago. The inventory situation was looking slightly better, with about nine months of available inventories.

The jury is out on whether the FOMC will announce a further rate cut on Wednesday. John Mauldin (Thoughts from the Frontline) argues as follows: “If I am wrong and the Fed was responding to the stock market [when cutting the Fed funds rate by 75 basis points on January 22], then we will likely not see a cut next week. But if we get another 50-basis-point cut, as I think we will, then it means the Fed is responding to concerns about the credit crisis. And we will get another cut at the next meeting and the next until we get down to 2% or below. A 50-basis-point cut takes the rate to 3%. It they had cut the rate by 1.25% next week, the market would have collapsed. Better to do it in two leaps is what I think they are thinking.”

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, January 25, 2008.

In addition to President Bush’s State of the Union Address on January 28 and the FOMC meeting on January 29 and 30, the next week’s economic highlights, courtesy of Northern Trust, include the following:

Markets
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week.

Source: Wall Street Journal Online, January 27, 2008.

Equities
US stocks started the shortened week markedly lower on Tuesday, following a sharp sell-off in global stock markets due to growing concerns about the overall health of the economy and Société Générale’s clean-up operations of its rogue derivatives trader’s positions. Markets, however, managed to recover and reclaimed higher ground as the week progressed. By the close of trade on Friday the Dow Jones Industrial Index (+0.9%) and the S&P 500 Index (+0.4%) were both in positive territory for the week, but the technology-heavy Nasdaq Composite Index (-0.6%) was less fortunate.

Following the surprise reduction in the Fed funds rate, the announcement of the tax stimulus package and a mooted rescue plan for bond insurers, interest-rate- and economically sensitive stocks gained strongly. Examples include banks (+11.4%), REITs (+8.6%), retailers (+5.4%) and small caps (+2.3%).

Elsewhere in the world, stock markets closed mostly in the red. Emerging markets, in particular, had a rough ride and lost 2.2% for the week, including the Shanghai Stock Exchange Composite Index’s decline of 8.1%.

Bonds
The lower stock markets at the start of the week helped drive the yields on government bonds lower, but the gains were given up as the week wore on, and prices closed the week little changed.

Currencies
Currency markets also experienced a fairly volatile week and saw the US Dollar Index closing the week 0.7% down. The euro, on the other hand, gained 0.2% on the back of hawkish comments from the ECB. Risk considerations resulted in investors exiting risky carry trades early in the week, pushing the yen to a two-and-a-half-year high against the dollar. As markets calmed down, the yen declined again to end the week lower against both the US dollar and euro.

Commodities
With most of the action concentrated on stock markets, commodities were somewhat out of the limelight during the past week. Base metals (-0.9%) and agricultural commodities (-1.9%) closed in the red, but crude oil (+0.9%) managed to claw back some of the previous week’s losses.

Precious metals, however, rallied strongly subsequent to the Fed’s rate cut, resulting in gold gaining 3.3%, platinum 7.3% and silver 1.7%. Both gold ($924.3) and platinum ($1 694.9) registered new all-time highs on Friday prior to some profit-taking setting in.

With the FOMC’s meeting on Tuesday and Wednesday, and Q4 GDP and January’s payroll numbers out on Wednesday and Friday respectively, another key week for financial markets lies ahead. Hopefully the words (and graphs) from the investment wise will assist in guiding us through the murky waters and keeping our investment portfolios in good shape.

US economy: Danger from all directions

Source: Slate, January 24, 2008.

Moody’s Economy.com: Survey of Business Confidence for World
“The global economy is stalling according to last week’s business confidence survey results. Sentiment is consistent with a contracting US economy, soft European and South America economies, and an Asian economy that is expanding at the low end of its potential. Expectations regarding the six-month outlook have never been as negative in the over five years of the survey. Confidence is weakest among real estate firms and financial institutions, but it has declined considerably in recent weeks among business service firms and even heretofore more optimistic manufacturers.”

Source: Moody’s Economy.com, January 22, 2008.

International Herald Tribune: US in role of wounded giant at Davos
“The United States has filled various roles at the World Economic Forum over the past decade: dot-com dynamo, benevolent superpower, feared aggressor, and now, wounded giant. On the first day of this conference, a parade of bankers, economists, and political officials expressed deep fears about the faltering American economy, peppered with blunt criticism of its institutions, chiefly the Federal Reserve, which some accused of sowing the seeds of today’s crisis.

“George Soros, the financier who made a fortune betting against the pound, went so far Wednesday as to say that the downturn would put an end to the long status of the dollar as the world’s default currency. ‘The current crisis is not only the bust that follows the housing boom,’ Soros said. ‘It’s basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency.’

“Signs of a new economic order abounded in this Swiss ski resort: the minister of commerce and industry of India, Kamal Nath, noted that China had overtaken the United States as India’s largest trading partner – buttressing his view that India could largely sidestep an American recession. The head of the National Bank of Kuwait, Ibrahim Dabdoub, said Americans who opposed sovereign wealth funds like the one run by his government needed to come to terms with the new reality.

“Nouriel Roubini, an American economist, whose frequent predictions of a downturn have made him something of a soothsayer in Davos, predicted the United States would suffer a recession lasting at least a year. He foresees a flood of defaults on car loans and corporate bonds, as well as a prolonged bear market. ‘The debate is not whether we’re going to have a soft landing or a hard landing,’ he said. ‘The question is only how hard the hard landing will be.’

“The Federal Reserve ‘made bad judgments’, said Joseph Stiglitz, the Nobel Prize-winning economist. ‘It looked the other way when investment banks packaged bad loans in non-transparent ways.’ The rate cut this week, Stiglitz said, would be too little, too late, because monetary policy usually takes between six months and 18 months to be effective, and the United States is in distress now.”

Source: Mark Landler, International Herald Tribune, January 23, 2008.

Asha Bangalore (Northern Trust): Fed cuts rate in surprise move
“In a surprise inter-meeting move, the FOMC lowered the federal funds rate and discount rate 75 bps to 3.5% and 4.0%, respectively.

“The statement noted that (1) ‘weakening economic outlook and increasing downside risks to growth’, (2) ‘deepening of the housing contraction’, and (3) ‘some softening of labor markets’ were reasons for the easing of monetary policy. The statement did not mention equity markets explicitly but cited that ‘broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households’. After the January 21 drop in global equity prices when the US market was closed, a continued downward trend today in these markets and the sharp drop in US equity futures markets this morning before opening probably played a role in today’s Fed action.

“Further easing of monetary policy is on the table, but the magnitude and timing is less clear. There could be preference to wait until the March 18 FOMC meeting to assess the impact of the monetary and fiscal policy easing put in place. The futures market has priced a 50 bps cut for the January 30 meeting. For today, we maintain a Fed on hold at the January 30 FOMC meeting, with a small possibility of further easing.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 22, 2008.

BCA Research: Fed trying to get ahead of curve
“The Fed does not like to act between meetings, and today’s rate cut was designed to send a signal that policymakers will do whatever is necessary to stop the slide in market confidence and minimize the damage to the economy. It is too late for the Fed to prevent a recession, they cannot rescue monoline insurers, and they cannot turn bad paper into good paper. But engineering a positively-sloped yield curve will help financial intermediaries, and ultimately will put a floor under the economy.

“The initial market reaction has been volatile, with downside risks remaining a huge concern. It is too soon to assume that a bottom in equity prices and peak in financial strains has been reached. Near-term caution is still warranted until credit spreads start to narrow.”

Source: BCA Research, January 22, 2008.

International Herald Tribune: Fed’s big easing a ‘once-in-a-generation’ event
“The US Federal Reserve, responding to an international stock sell-off and fears about a possible US recession, cut its benchmark interest rate by three-quarters of a percentage point Tuesday, an aggressive move that came a week ahead of a regularly scheduled meeting of the central bank.

“The move, unusual in both its scale and its timing, underscored the severity of the current strains facing the US economy.

“‘It’s a once-in-a-generation event,’ Mark Zandi, chief economist at Moody’s Economy.com, said. In recent years, the Fed has rarely acted between scheduled meetings of the committee, and almost always in increments of one-quarter or one-half point. It was the biggest single cut since October 1984.

“Jan Hatzius, chief US economist at Goldman Sachs, said the timing of the cut, which came after a significant sell-off in Asian and European stocks on Monday, may turn market performance into a referendum on the Fed’s move. ‘By itself, it’s not necessarily a wrong thing to do if you’re worried about systemic stability,’ Hatzius said. ‘Nevertheless, it’s a little tricky because it ties you from a short-term perspective to what happens in the stock market.’ A sell-off could be viewed as a vote of no confidence from investors, he said.

“‘This is an effort to catch up and get ahead of flagging confidence in the weakening economy,’ said Zandi, who has criticized the Fed for not responding faster to the current crisis. A smaller cut ‘might have created more panic among investors,’ he added. ‘But the fact that they moved in such a decisive way strongly signals that they are going to work very aggressively to shore up confidence in the economy.’”

Source: Michael Grynbaum and John Holusha, International Herald Tribune, January 22, 2008.

Bloomberg: Pimco’s Gross says Fed rate cut a ‘sad testament’
“‘It’s a sad testament to think the Fed has to cut interest rates eight days in front of a meeting to salvage the equity markets,’ said Bill Gross, the founder and chief investment officer of Pacific Investment Management Co, in a Bloomberg interview. ‘The US economy is in a rather sad state of affairs in that it depends on housing and stock prices to keep going.’”

Source: Kathleen Hays and Deborah Finestone, Bloomberg, January 22, 2008.

Times Online: Fed rate cut triggered by fear of bond insurance collapse
“Fears that America’s bond insurance market could implode triggered the US Federal Reserve’s biggest interest rate cut for more than a quarter of a century, Wall Street economists claimed yesterday.

“Market analysts said that Wall Street had spent last week gradually realising the grave consequences of a major bond insurer defaulting on its commitments and attributed the surprise rate cut to averting such a crisis.

“As well as guaranteeing company debt issues, the bond insurers underwrite paper from local government in the United States. The failure of a bond insurer would reduce funding for state governments or increase its cost, threatening infrastructure projects such as building of schools and roads, slowing the US economy further.”

Source: Suzy Jagger, Christine Seib and Tom Bawden, Times Online, January 23, 2008.

Financial Times: Banks pressed to bail-out bond insurers
“Leading US banks are under pressure from New York state’s insurance regulator to provide as much as $15 billion to support struggling bond insurers, people familiar with the matter said on Wednesday night.

“There is widespread concern that rating agency downgrades of the specialist insurers known as monolines could force a fresh round of writedowns by banks, which could damage already battered investor confidence. This has led to speculation that banks would band together to prop up the insurers, which guarantee payments on thousands of billions of dollars worth of bonds issued by municipal governments and other borrowers.

“People familiar with the matter said the specifics of a possible capital infusion had yet to be decided …”

Source: Ben White, Aline van Duyn and Francesco Guerrera, Financial Times, January 24, 2008.

John Mauldin (Thoughts from the Frontline): Credit Default Swaps reason for concern
“There are a total of $45 trillion Credit Default Swaps (CDSs) outstanding. No one is really sure who owes what and to whom, and what the risk is that there may be no one to pay that CDS when it comes due? The entire mess is going to have to be unwound in the coming quarters. It may take a year or more.

“I think the concern that there is the potential for a much worse credit crisis than we are currently experiencing is what is driving the Fed. They are looking at the problem from the inside, and realize that they simply have to engineer a much steeper yield curve to allow the banks to make enough profits so that they might be able to grow their way out of the crisis over time.

“If I am wrong and the Fed was responding to the stock market [when cutting the Fed funds rate by 75 basis points on January 22], then we will likely not see a cut next week. But if we get another 50-basis-point cut, as I think we will, then it means the Fed is responding to concerns about the credit crisis. And we will get another cut the next meeting and the next until we get down to 2% or below.

“A 50-basis-point cut takes the rate to 3%. It they had cut the rate by 1.25% next week, the market would have collapsed. Better to do it in two leaps is what I think they are thinking. We will see. And it is not just the Fed that is concerned.”

Source: John Mauldin, Thoughts from the Frontline, January 26, 2007.

MarketWatch: Stimulus deal announced by White House
“The White House and the House leadership have reached an agreement on a plan to juice the economy this year with $140 billion in temporary stimulus measures. The plan would give most US workers a tax rebate of $300 to $1 200. A vote in the House was promised at ‘the earliest date’.

“It would give businesses tax breaks to invest in new equipment this year, and would boost the limit on mortgages eligible to be purchased by Fannie Mae and Freddie Mac. House Speaker Nancy Pelosi and Republican leader John Boehner said the plan was a true compromise, with neither totally satisfied. But both said they believed the plan was essential and would help the economy this year. Senate leaders have not agreed to the plan yet.”

Source: Rex Nutting, MarketWatch, January 24, 2008.

Joseph Stiglitz (Times Online): Day of reckoning in the US glasshouse
“Even the Fed is beginning to realise that, although misguided monetary policy and inadequate financial regulation got the US into the mess, reversing course will not get it out.

“Can fiscal policy do the trick? President Bush’s cureall for any of the nation’s ills – making the 2001 and 2003 tax cuts permanent – will drive up the deficit but not the economy. In some sense, they are at the root of the problems that have ensued. Tax rebates for lower-income Americans will have the biggest stimulant per dollar of deficit (in the jargon, the biggest bang for the buck). And it will be fast-acting.

“But will the Bush Administration, so long focused on helping the rich, be willing to change course? And is it wise to encourage America on its consumption binge? What America desperately needs is more investment, in infrastructure, in research, in education. This, too, would provide a big bang for the buck. But while defence spending has soared, including billions for weapons that don’t work against enemies that don’t exist, will it be willing to countenance more government spending in these areas?

“This is an election year and anything is possible. My betting is that the Administration won’t want to admit just how bad the economy is, and that even if a compromise is achieved, it will be too little too late.”

Source: Joseph Stiglitz, Times Online, January 21, 2008.

Bill King (The King Report): Questions about state of the US economy
“… how about the clowns, including Bush, who keep averring that the economy is sound and whatever downturn appears will be short and shallow? Then why are 3rd World Countries bailing out the leading US financial institutions and the Fed cannot allow a 20% decline in stocks?”

Source: Bill King, The King Report, January 23, 2008.

Asha Bangalore (Northern Trust): Further slide in US house prices
“On a year-to-year basis, the median price of an existing single-family home fell 6.5% in December, the second largest drop on record, with the 6.7% year-to-year drop in October 2007 holding the record for the largest decline.

“The inventory of unsold existing homes fell to a 9.6-month supply from 10.1-month supply in November. The high level of inventories suggests that additional price declines in 2008 are likely. Unlike the market of new homes, sellers of existing homes can remove signs and postpone sales, which is probably what is occurring.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 24, 2008.

BCA Research: Asset markets – already discounting a recession
“Several indicators suggest that a recession is already priced into risky assets. Our press indicator for recession has surged in recent weeks, in line with the sharp drop in both economic sentiment surveys and net forward earnings revisions. This indicator is now at readings consistent with past recessions.

“Similarly, the collapse in the global stock-to-bond ratio is on par with previous recessions or crashes in risky asset prices. Many equity sectors have already experienced a bear market, including US small caps which are down more than 20% from their highs.

“In addition, the fed funds rate is expected to plunge to 2% by next January, which leaves real short rates at similar levels to past (mild) recessions. Corporate bond spreads have also blown out to recessionary levels in both the US and Europe. In fact, the gap between US corporate spreads and underlying fundamentals is now at a cyclical extreme. Bottom line: Market participants have adjusted rapidly in recent weeks and are already factoring in a recession.”

Source: BCA Research, January 23, 2008.

Jeremy Grantham (GMO): Cash is king
“As was the case with Japan’s problems in a very severe credit crisis, the issue of which bank survives and which doesn’t is more about politics than economic solvency. Many financial companies will approach technical insolvency before this crisis plays out and before they desperately raise new capital. This is not another shot across the bow as March 2007 and April 2006 were; this is the real McCoy.

“So what to buy? I’m afraid cash is the ugly answer that no one ever wants to hear. For the first time in many bear markets traditional value stocks are unlikely to help much and may even hurt as they entered the decline badly overpriced. And once again if you literally cannot resist buying some stocks, we recommend a mix of the highest quality US blue chips and emerging markets.”

Source: Jeremy Grantham, GMO, January 22, 2008.

Nouriel Rubini (RGE Monitor): When the US sneezes the rest of the world gets the cold
“The collapse of global equity markets on Monday, January 21 is not just an episode of financial contagion from the US stock market to other stock markets. It rather signals that global stock markets are now beginning to price the following things.

“First, the US recession is unavoidable and has already started; and this recession will be ugly, deep and severe, much more severe than the mild 8-month recessions in 1990 – 91 and 2001.

“Second, the rest of the world will not decouple from the US since many trade, financial, currency, policy, confidence links lead to a transmission of negative growth shocks in the US to the rest of the world that will lead to a sharp global growth slowdown: 2008 will be the year of recoupling rather than decoupling.

“Third, the US stock market has already started to reflect in the last few weeks the consequences on earnings and corporate profitability of a severe US recession.

“Fourth, a growing realization that even aggressive Fed easing will not prevent this severe recession, i.e. that we are at the last leg of the stock market’s sucker’s rally and that the Bernanke put has very little value as massive financial losses will increase regardless of what the Fed does.

“Fifth, other global stock markets are now starting to price the effects of the US hard landing on the rest of the world growth, the phenomenon of recoupling.

“Thus, the Monday Massacre in global stock markets is – more than a case of financial contagion – a revenge of economic fundamentals as investors are waking up from the delusion that the US would avoid a hard landing and that the rest of the world could decouple from such hard landing.”

Source: Nouriel Rubini, RGE Monitor, January 21, 2008.

Jeffrey Saut (Raymond James): Start compiling a buy list for stocks
“Last week Treasury Secretary Paulson, when referring to the potential economic stimulus plan, averred, ‘This is not an emergency. There is an urgent need.’ To which we ask, ‘If this is NOT an emergency, then why is it urgent?!’ Clearly the politicos are worried about a recession and are pulling out all the ‘stops’ to prevent the normal business cycle … While we don’t think the recession question will be answered for months, we do think the selling stampede is coming to an end and suggest getting your ‘buy list’ together for at least a trade and maybe something more.

“And lo and behold, in a surprise move the Fed has panicked this morning and cut the Fed Funds target interest rates by 75 bp to 3.5%. It will be interesting to see if like us the Street interprets the Fed move as ‘panic’. Whatever the outcome, we think a change for the better is approaching … So get ready, get set.”

Source: Jeffrey Saut, Raymond James, January 22, 2008.

David Fuller (Fullermoney): US rate cut positive for global stock market sentiment
“… what will be the effect of this reactionary rather than anticipatory move to cut rates by the Fed today? It will help to cushion downside risk for the stock market and economy somewhat, although not nearly so much as would have been the case if rates had been lowered ‘like an elevator’ some weeks ago. Unfortunately, risks increased rapidly as the Fed fell further behind the curve. Sentiment deteriorated and US stock market indices completed top formations. Contagion and the Wall Street leash-effect caused most other stock markets to capitulate recently.

“The US’s economic problems are real and a serious concern, but there is also a healthy multinational / export sector, profiting from stronger growth outside the States. Equity valuations are quite reasonable, even after allowing for profit downgrades, and they are very competitive relative to long-dated government bonds.

“Assuming that the Fed is now determined to catch up with the curve of events – it isn’t there yet but has taken a big step today – further rate cuts would help a weak economy, as would the emergency stimulus package. This would lend support to the stock market.

“Assuming that we see additional rate cuts of at least another 100 basis points in coming months, which I believe are necessary and likely. Wall Street should avoid the grinding, lengthy bear market that many fear. However it will take time to repair technical damage, not least for the financial sector.

“Today’s move by the Fed makes it much more likely that other central banks will also lower rates, in regions where there are legitimate growth concerns. This will do no harm to global stock market sentiment.

“Technically, today’s rebounds from the day’s lows for stock market indices in Europe and the Americas suggest that we have seen climactic lows of at least near-term significance.

“The rate cut is a big headwind for the US dollar, but bullish for precious metals.”

Source: David Fuller, Fullermoney, January 22, 2008.

John Hussman (Hussman Funds): Bear market rally quite likely
“The recent bull market began at the highest valuations of any prior bull market in history. It has predictably achieved below-average overall returns, and the cycle isn’t even over yet. Though every market cycle is different, an ‘average’ bull market represents a span of about 3.75 years, with total returns averaging about 27% annually, followed by a bear market of about 1.25 years, with total returns averaging about -27% annually. That means that, on average, a typical bear market loss of just over 30% has shaved a typical bull market gain of 145% down to a cumulative return of about 65% (for a full cycle of about 5 years and overall annual total returns of about 10.6%).

“The failure to understand the dynamics of market cycles is a major reason why investors repeatedly overextend their risk near market peaks, hold onto their stocks over the full course of a bear market, and finally abandon stocks near market troughs. Though less than half of a typical bull market’s gains typically remain by the end of a bear market, those bear markets rarely move in a straight line. Instead, they typically include several declines of 10% – 20%, punctuated by very hard rallies. As I’ve noted before, the 2000-2002 decline, which took the S&P 500 down by nearly half, included three separate advances of about 20% each. These advances serve to keep investors ‘holding and hoping’, as Richard Russell would say.

“It’s important to recognize that ‘one-fell-swoop’ market plunges typically feature rising interest rates, so even if the US market follows through on the international weakness we saw on Monday, a bear market under current conditions would in all likelihood be punctuated by some powerful recoveries (though ultimately temporary – probably several weeks in duration) with additional failures later.

“Given my view that the US economy has probably entered a recession, it appears fairly unlikely that the full decline in the S&P 500 will ultimately fall short of a minimal bear market decline of say, 20%. Taken from the market’s recent high, that would set an initial expectation at about 1260 on the S&P 500. Of course, the average bear market has typically exceeded 30%, but I would be surprised if the market weakened below that level without producing a sustained clearing rally first.”

Source: John Hussman, Hussman Funds, January 21, 2008.

John Authers (Financial Times): Earnings cycle – a headwind for stocks
“It is popular in the US to value equities by comparing the earnings yield on stocks with that available on Treasury bonds – a system known as ‘the Fed model’ because Alan Greenspan, the former chairman, once appeared to use it while giving evidence. With bond yields at their lowest in four years, this has prompted some analysts to find ‘compelling’ valuations. However, this does not take account of the level of earnings. Earnings tend to follow a cycle and so earnings multiples tend to be lower when earnings appear to be cyclically high. The market entered the current turbulence just as S&P earnings had grown 10% or more for a record 14 consecutive quarters.

“Once multiples are adjusted for the earnings cycle, by comparing prices to average earnings over the previous 10 years, the market no longer looks particularly cheap. On this crude measure, the S&P is priced at a multiple of 26.6 – significantly down from the 32.3 level which it hit in May last year, but far higher than is usually seen when the market hits bottom. Cyclically adjusted multiples were lower than this immediately before the Black Monday crash of October 1987.

“Earnings themselves are another source of uncertainty. According to Thomson Financial, analysts now expect S&P 500 earnings to fall by 19%, year on year, in the fourth quarter. When the quarter started, they expected growth of 11.5%. The sharp fall in Apple’s share price in after-hours trading on Tuesday following its results showed that the market remained vulnerable to negative earnings surprises. This suggested that the market had still not capitulated.”

Source: John Authers, Financial Times, January 22, 2008.

Richard Russell (Dow Theory Letters): How long will bear market last?
“Obviously I don’t know. But this is a question that’s been bothering me. Normally and based on past history, bear markets tend to last for a quarter to a third as long as the preceding bull market. The bull market in stocks started in 1980 and ended in 2000 or arguably in 2007 at the point where both the Dow and the Transports recorded their last joint highs.

“And I’m wondering – what if this bear market lasts four, five or six years? As you know, the big ‘mover’ in both bull and bear markets are the price/earnings ratios, the multiples people are willing to pay for stocks. As of Friday, the price-earning ratio for the S&P 500 was over 18. In big bear markets, the P/E ratio can decline to as low as 5. Let’s hope this bear market doesn’t end with a P/E of 5 or 6 or 7 for the S&P. That would be an utter disaster.”

Source: Richard Russell, Dow Theory Letters, January 22, 2008.

Tony Kolton (Moneyweb): 2008 will be up year for US stock market
“… I don’t think we’re out of the woods yet. A long, long, long-term view – we’ve had two horrendous Januaries in election years in the United States. They were in 1900 and 1932. In both instances the decline in January caught itself; it caught itself and it stopped; it rallied – turned around March, and it came down and bottomed out in July, and actually ended up the year ahead. So I expect history will repeat itself and the same thing will happen.

“Also … there’s been 12 discount rate cuts in presidential election years since 1960. From the close of the date of the cut until the end of the year, the stock market in the United States has always, always been up. Always – never failed to work. I expect that that will pan out too, and we’re going to end the year on a higher note. But I do believe we’re going to … rally, maybe make a high in March, hit a low in July, and then that will be it. We’ll be up and out from July to the end of the year. And it’s based on history and that’s the way these things play up.”

Source: Tony Kolton, Moneyweb, January 22, 2008.

Bill King (The King Report): Trade of a lifetime – short US bonds
“There has been extraordinary flight to safety over the past year. This has fostered an enormous US Treasury rally. But soon, especially as the recession intensifies, investors’ focus will change from the credit concerns in ‘the system’ to concern about the credit of the US.

“This could unleash a severe bear market in bonds that will be exponentially compounded by the $700 trillion+ derivatives market because over 2/3 of those derivatives are interest rate related. And when those traders start getting ‘gammaed’ to death, the mother of all bubbles, unwarrantedly low US interest rates, will violently burst.

“Very soon, getting short US bonds will be the trade of a lifetime. And anyone with less than 25 years of experience in the financial industry has not seen a vicious bond bear market.”

Source: Bill King, The King Report, January 24, 2008.

Bloomberg: Europe starts to feel pinch as US slowdown spreads
“The European economy may be starting to suffer collateral damage from the US subprime mortgage slump. Banks are making borrowing harder, industrial production is shrinking and investor confidence is waning just as the US skirts recession. With the euro’s appreciation to a record hurting exports, more economists are betting the European Central Bank will be forced to lower interest rates.

“‘There is a clear downtrend in the economy now,’ said Michael Schubert, an economist at Commerzbank AG in Frankfurt. He revised his ECB forecast last week and predicts two cuts by October after previously projecting one in the final quarter.

“The ECB has so far refused to follow the Federal Reserve and the Bank of England in lowering borrowing costs as contagion from the US housing recession spreads, arguing that inflation pressures are too strong. Government and industry surveys this week may nevertheless show growth risks are mounting and finance ministers meet in Brussels today to discuss the outlook.

“Europe’s manufacturing and services industries probably expanded at the slowest pace since June 2005 and German business confidence fell to the lowest in two years, according to surveys of economists by Bloomberg News.”

Source: Simon Kennedy, Bloomberg, January 21, 2008.

GaveKal: European LIBOR rates lagg US
“The Fed has successfully brought its LIBOR rate significantly down; the same cannot be said in Europe …”

Source: GaveKal – Checking the Boxes, January 25, 2008.

BCA Research: ECB drops the ball
“The European Central Bank (ECB) has a history of lagging the curve but yesterday’s comments were especially misguided and disruptive. In order to bring an end to the credit crunch, allow market participants to gain composure and stabilize the global economy, the major central banks need to provide a collective response. The Fed’s bold move on Tuesday was a significant step in this direction, helping to ease investor panic. However, ECB comments today threaten to derail healing in economic sentiment, sending investors running for safety.

“Specifically, ECB President Jean Claude Trichet stated: ‘Particularly in demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility’. It is hardly the time to worry about price pressures: The inflationary impact of food and energy prices has peaked and the world economy is experiencing a disinflationary shock from the US (and potentially UK) housing bear market and slowing global growth. Even the euro area economy has started to downshift materially in response to extremely tight monetary conditions. Bottom line: Stay cautious on risky assets until policymakers capitulate. We also reiterate our overweight euro area bond call and preference over Treasurys.”

Source: BCA Research, January 24, 2008.

Eoin Treacy (Fullermoney): ECB will have no choice but to cut rates
“While I suppose it is laudable of the European Central Bank (ECB) not to give in to peer pressure, I also believe that they will have no choice but to cut rates before the end of the year. The interest rate differential between the US dollar and the Euro is only going to get larger and once the unwinding of leverage has run its course (we are already seeing evidence of this) then the Euro is likely to set new highs. Depending on how large this move is, European companies who consolidate their earnings in Euros will have larger problems than is already the case. The ECB may well then start to see the evidence of slowing growth, they so far fail to recognize.”

Source: Eoin Treacy, Fullermoney, January 24, 2008.

Times Online: Chinese banks facing write-downs
“Signs emerged yesterday that China, which will be the biggest single national contributor to global growth this year, could be hit by serious losses at its banks from the US sub-prime home loans debacle. Until recently, investors had believed that Chinese banks were well-insulated from the crisis. But that assumption was challenged yesterday by warnings from two leading banks that big Chinese banking groups could be forced to write-down millions in losses on sub-prime investments.

“China’s financial regulator said banks in his country had also built up substantial amounts of bad loans during an investment boom.”

Source: Gary Duncan and Roger Boyes, Times Online, January 22, 2008.

Bloomberg: Japan’s inflation rate doubles
“Japan’s inflation rate doubled in December to the fastest in more than nine years, as companies passed rising oil and commodity costs to consumers. Core consumer prices, which exclude fresh food, climbed 0.8% from a year earlier, the statistics bureau said today in Tokyo.

“‘The global economy is slowing while prices of food and energy keep advancing,’ said Hiroshi Shiraishi, an economist at Lehman Brothers in Tokyo, who expects the central bank to keep interest rates on hold this year. ‘That’s the worst combination for the Japanese economy, which depends on exports and has stagnating domestic demand.’”

Source: Mayumi Otsuma, Bloomberg, January 25, 2008.

David Fuller (Fullermoney): Yen steadily edging higher
“The Yen has been steadily appreciating against the US dollar since June … and remains in an overall uptrend. The Yen’s appreciation of 14.26% is symptomatic of the gradual unwinding of carry trades in that currency and the gradual move to greater risk aversion amongst leveraged traders. However, carry trades have also been moved to other currencies such as the US dollar, which remains in a long-term downtrend and has the possibility of further rate cuts. This may also be a factor in the continued strength of the Yen as it removes a proportion of those who would have normally been short of the currency.”

Source: David Fuller, Fullermoney, January 23 2008.

Peter Tasker (Dresdner Kleinwort): Japan’s small-caps trading at bargain prices
“Japan is the only major market in the world to have experienced a savage bear market in small-capitalized stocks, says Peter Tasker, analyst at Dresdner Kleinwort. Japan’s Mothers market for start-ups has slumped about 78% from its peak; 61% of stocks capitalised below Y100bn ($938m) are currently trading below book value, and 26 per cent have a price/earnings ratio of 10 times or less, he says.

“‘What asset class in the world’s major market is as cheap?’ He says that on most criteria, small-cap Japan is better value than large-cap Japan, which in turn appears to be better value than representative US stocks. The area where Japan is weaker is earnings quality, though here too small-caps put in a better showing.

“Mr Tasker says he is often asked what the ‘catalyst’ is to release value in Japanese equities. ‘When stocks become cheap, you do not need a catalyst,’ he says. ‘All you need is for the price-to-book ratio to stabilise. For the low-p/b, low-p/e group, even with an earnings decline of 20%, growth in shareholder value [growth in book value plus dividend yield] will still be at least 8% per year.

“‘In bear markets, valuations often overshoot on the downside, but there are few asset classes in the world that can currently match the historically low valuations of small-capital Japan.’”

Source: Peter Tasker, Dresdner Kleinwort (via Financial Times), January 24, 2008.

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The Chinese calendar proclaims this as the Year of the Rat. Based on the behavior of economies and financial markets over the past few months, investors would be forgiven for thinking that a plague has descended upon the financial system. But on occasion it is useful to step back from the day-to-day shenanigans of markets and take a bird’s-eye view of events.

When it comes to evaluating how well people “read” the macro picture of financial markets, it is important always to distinguish between skill and luck. And it is really only with the passing of time, or evolvement of a number of market cycles, that one can separate the wheat from the chaff.

Donald Coxe, Global Portfolio Strategist of BMO Financial Group, is one of a select group of analysts that have been remarkably right on the “big picture” outlook for many years. My market views essentially concur with Donald’s investment recommendations as published in the January edition of Basic Points, entitled “The Year of the Rats”. I have therefore deemed it opportune to share his words of wisdom with you in the paragraphs below.

Source: Victor Adair

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The stock market continued its downward trajectory during the past week, experiencing wild swings on the back of a barrage of bad news in the financial sector, and ongoing concerns about the housing and credit markets weighing on investor sentiment.

This prompted Bill King (The King Report) to raise the following questions about Fed chairman Ben Bernanke’s troubled facial expression: “How dreadful has sentiment about the economy and financial system become? If one picture is worth a thousand words, what are two pictures worth?”

Bernanke’s testimony before a congressional committee on Thursday reaffirmed the market’s worries about the health of the economy. He admitted that the tumbling house prices, increased energy costs, falling consumer spending, increasing unemployment and weak stock market performance were more than likely to drag down US economic growth. Bernanke expressed his support for significant fiscal and monetary stimulus as a pre-emptive strike against a US recession. Despite these pronouncements the stock market plummeted by more than 300 points.

On Friday President Bush broadly outlined a plan for roughly $150 billion’s worth of tax breaks, rebates and unemployment benefits to boost the slowing economy and help stave off a recession. This announcement, however, could not prevent stocks from sliding further, especially as concerns mounted that the downgrading of bond insurers dealing in credit default swaps could trigger another wave of huge debt write-downs.

“I hope I’m wrong, but I’m thinking that a large economic storm is building, and it’s aiming to hit hard in the weeks and months ahead,” said Richard Russell, 83-year old author of the Dow Theory Letters.

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance chart.

Economy
Based on a recent CNN poll, it’s clear that the priorities and worries of US voters (i.e. consumers) are changing. In a November poll, 29% were worried about the economy, 28% were worried about the war in Iraq, 18% were worried about healthcare, 10% were worried about illegal immigration, and 12% were worried about terrorism. In the latest poll, 35% were worried about the economy, 25% were worried about the war in Iraq, 18% were worried about healthcare, 10% were worried about illegal immigration, and only 9% were worried about terrorism.

The bulk of the economic statistics reported during the past week, including soft retail sales, falling housing starts and a declining Index of Leading Economic Indicators, reaffirmed the US’s economic woes and the precarious position of consumers. BCA Research summarized the implications for the Fed’s meeting at the end of the month as follows: “While some FOMC members remain concerned about upside inflation risks, this will not prevent further major rate cuts. A stimulative Fed will not lead to an early improvement in the economy, but should cushion the downside.”

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, January 18, 2007.

Next week’s economic highlights include Initial Jobless Claims and Existing Home Sales on Thursday.

Markets
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week.

Source: Wall Street Journal Online, January 20, 2007.

Concerns about a US recession again clouded the financial markets during the past week and the subprime woes continued to unfold as more write-downs and depressed earnings were reported.

The bears made their presence felt and stock markets slumped across the globe with almost panicky selling being encountered. This is evidenced by the steep fall in both the MSCI World Index (-5.1%) and emerging markets (-6.4%). Under the circumstances, the Japanese Nikkei 225 Average did relatively well with a more modest decline of 1.8%.

The losses of the US stock markets are mounting as illustrated by the following year-to-date returns: Dow Jones Industrial Index: -9.5%; S&P 500 Index: -10.4%; Nasdaq Composite Index: -12.5% and Russell 2000 Small Cap Index: -12.8%. The latter has declined by 21.5% since its high in July 2007, thereby now qualifying as being in a bear market as the “official” definition of a 20% decline has been met.

On the currency front, the Japanese yen gained strongly as a result of the reversal of the carry trade, putting pressure on a number of high-yielding currencies. The US Dollar Index found slight gains on hopes that the White House’s stimulus plan will help ease credit market problems. The euro, on the other hand, declined as expectations for the ECB shifted from holding rates steady to perhaps joining the Fed in cutting rates.

Government bond yields fell further around the world as the global economic outlook worsened and investors switched stocks to what is perceived to be a safe-haven asset class. In the US, the real 10-year bond yield traded at its lowest level since the 1970s.

Commodities, in general, came off their highs on the back of the economic slowdown and heavy profit-taking after the recent rallies. Agricultural commodities, however, continued their uptrend and posted a gain of 2.1% for the week.

Now for a few news items and some words (and graphs) from the investment wise that will hopefully assist in guiding us through the stormy waters and making the correct investment decisions during the shortened week ahead.

Source: Jim Sinclair’s Mineset, January 17, 2008.

Asha Bangalore (Northern Trust): Fiscal stimulus package and impact on economic activity
“This morning, President Bush announced that a $140 billion stimulus package will be put in place soon. A fiscal stimulus package can help lift aggregate demand and reduce the risk and severity of a recession and provide broader support to actions of the Federal Reserve. This is the rationale behind enacting an expansionary fiscal policy. A variety of options are available to design this package with tax rebates for individuals and tax breaks for businesses. Chairman Bernanke provided his blessings for the stimulus package in yesterday’s testimony. There is bi-partisan support for this effort.

“Questions about the benefits of a fiscal stimulus package made up a major part of the Q&A session in Bernanke’s testimony. As an example, Bernanke answered that the impact of a $100 billion tax rebate to households was expected to result in a $60 billion increase in consumer spending. This has enormous significance. As an exercise, when we plugged in $60 billion spending in our GDP forecasting model, holding other things constant, it resulted in a nearly 2.0% annualized increase in real GDP in the quarter it was spent. The multiplier effect of this spending is a more complex exercise. Our exercise is for illustrative purposes only. Studies have found that the rebate is probably spent over two quarters. By implication, the $140 billion package should have a larger impact than the example cited in the testimony.

“Fiscal policy has a relative advantage compared with monetary policy when considering the timing issues of policies because the impact lag of fiscal policy is smaller in comparison with monetary policy. By contrast, the implementation lag of fiscal policy is longer than monetary policy. Therefore, the emphasis is on enacting the package in a timely manner. If the Fed lowers the Fed funds rate to 3.00%, eventually, matching our forecast, it would be a cumulative ease of 225 basis points. The impact of this large cut in the federal funds rate will be visible only several months ahead unlike the impact of fiscal policy changes.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 18, 2008.

Bernanke, Paulson, whatever: you financial types all look alike
“Amusing clip from Fed Chair Ben Bernanke’s testimony today on Capitol Hill. Apparently from a Congressional point of view in an election year – or at least from the perspective of 13-term (!) Democratic Budget Committee member Marcy Kaptur – all these damn financial types look the same.”

Source: Paul Kedrosky’s Infectious Greed, January 17, 2008.

BCA Research: Bernanke to markets – we are not asleep
“Fed Chairman Ben Bernanke’s remarks imply good odds of a 50 basis point rate cut later this month. Bernanke could not have been clearer. Having provided a good overview of how the current situation developed, he set out to reassure the markets that he is highly attuned to downside economic risks. The key phrase was that ‘the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner … to counter any adverse dynamics that might threaten economic or financial stability’.

“While some FOMC members remain concerned about upside inflation risks, this will not prevent further major rate cuts. A stimulative Fed will not lead to an early improvement in the economy, but should cushion the downside, and ensure that equities move higher over the course of the year.”

Source: BCA Research, January 15, 2008.

The Wall Street Journal: A quote from 1993
“History shows that once nominal growth slows in a heavily indebted economy, there can be no recovery until the excess debt is eliminated. Political efforts to expand debt do nothing to lift the burden of debt service, which is the cause of slow growth and faltering incomes in the first place.

“Too many people have become complacent about deflation. But watch out. Debt has grown too large to be sustained out of cash flow. As soon as the balance sheet is depleted, a deeper crisis of asset liquidation will catch the world by surprise.”

Source: James Dale Davidson, The Wall Street Journal, 1993.

Goldman Sachs: Calling a US recession
“This week our US macro economists reduced their forecasts for US growth. We now expect a recession in the US with the 1st quarter of 2008 showing no growth, the 2nd and 3rd quarter negative growth of -1% and only +0.5% in the final quarter of this year.

“The change to a more negative view was made after analyzing the poor data that has been coming out of the US since the start of this year, particularly the unemployment rate which rose by 0.3% to 5%. Historically, whenever the unemployment rate has risen by 1/3% or more, the US has fallen into a recession.

“The changes have significant impact on our forecasts for a number of asset classes. We now expect the EUR/USD rate to show further USD weakness. We forecast 1.51, 1.51 and 1.40 in 3, 6 and 12 months respectively. USD fixed income will benefit from stronger easing by the Federal Reserve (2.5% interest rates for 2008). Equities will need to be positioned more defensively (overweight pharma, consumer staples, utilities, underweight tech, industrials and financials).

“These changes will also affect the growth forecasts of other regions. We have maintained that other regions such as the Euro zone and Asia would show some resilience unless the US outlook became worse, as we now predict. We have already adjusted the outlook for Japan, where we now also expect a recession in 2008.”

Source: Thomas Stolper, Fiona Lake and Jens Nordvig, Goldman Sachs, January 10, 2008.

Asha Bangalore (Northern Trust): Inflation is a problem, but FOMC should ease monetary policy on January 30
“The Consumer Price Index (CPI) rose 0.3% in December following a 0.8% increase in the prior month. The energy price index advanced 0.9% in December putting the year-to-year increase at 17.4%. The food price index moved up 0.1%, with the index advancing 4.9% on a year-to-year basis. The sharp increases in food and energy prices helped to raise the overall CPI by 4.1% in 2007 versus a 2.5% gain in 2006.

“Conclusion – Bernanke’s comments on January 10 clarified that in the inflation-growth debate the Fed now sees the risk of weakening economic conditions as the predominant risk. He also remarked that the Fed stands ready to take substantive action to jump start a stalling economy. True, the CPI rose 4.1% in the twelve months ended December 2007. At the same time, industrial production fell at an annual rate of 1.0% in the fourth quarter. In addition, the sharp increase in the unemployment rate and a negligible expansion of payrolls in December, the below 50 reading of the ISM manufacturing composite index, soft retail sales in December and the continued decline in equity prices are factors building the case for further easing of monetary policy. Today’s economic reports have not changed our forecast of a 50 bps cut in the federal funds rate on January 30 to 3.75%.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 16, 2008.

Kiplinger Business Resource Centre: Lasting housing woes paint a grim economic picture
“For housing to return to good health – with the solid housing starts and sales of new and existing homes near the rates seen in the late 1990s, if not the red-hot figures of 2004 and 2005 – it’s likely to take at least three more years.

“For now, the housing sector is caught in a sickening downward spiral. New construction is still much too high. At 2.5%, the ratio of vacant unsold homes to total homeownership is 50% greater now than it had been for 20 years. There’s an excess inventory of up to a million homes. To work that off, housing starts must drop by an additional 25%, to about a million a year. But we expect starts of 1.2 million or so this year, down just 11% from last year’s figure of 1.35 million.

“One reason: Too much of builders’ money is tied up in development – the cost of buying finished lots, impact fees and permits, building roads, installing water and sewer lines and so on. To keep cash flowing and minimize losses, they keep building homes and hoping to sell them. Mario Ricchio, housing industry analyst with Zach’s Investment Research, says, ‘If builders could shut down for two years, they would eliminate all the overhang. Of course, that’s not going to happen. They have to generate cash flow.’

“More foreclosures will worsen the problem in the short term. Two million homeowners face a reset of adjustable mortgages both this year and next.”

Source: Jerome Idaszak, Kiplinger Business Research Centre, January 2008.

Asha Bangalore (Northern Trust): Housing starts record severe weakness
“Homebuilders cut back again on breaking ground for new homes in December. Starts of new homes fell 14.2% in December to an annual rate of 1.006 million units. The December reading is the lowest since April 1991. Housing starts are down 56.1% from the peak reading of 2.292 million in January 2006 which is close to declines associated with prior recessions.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 17, 2008.

Asha Bangalore (Northern Trust): US Index of Leading Economic Indicators offers support for recession forecast
“The Index of Leading Economic Indicators (LEI) fell 0.2% in December after a similar decline in November. The October estimate was revised to a 0.7% drop from the earlier estimate of a 0.5% decline. The LEI has now declined in four out of the last six months.

“The quarterly average of the LEI is down 0.6% from a year ago. Historically, negative year-to-year changes in the quarterly LEI are associated with recessions with the exception of the drop in 1967 when the economy was weak. Larger declines will be necessary to confirm that a recession is underway. However, the fact that the LEI has now declined in two out of last three quarters on a year-to-year basis is a strong signal that should be watched.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 18, 2008.

Asha Bangalore (Northern Trust): CEO Confidence Index lowest in current cycle
“Confidence about the economy … is captured in the CEO Confidence Index. This index fell to 39 in the fourth quarter, down from 44 in the third quarter and the lowest in the current expansion which began in November 2001. Historical evidence suggests that the current reading of this index is approaching levels seen in a recession.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 15, 2008.

John Mauldin (Thoughts from the Frontline): Credit default swaps – the continuing crisis
“… the big story for 2008 would be the counter-party risk for credit default swaps. That story is coming faster and larger than I thought. Bill Gross of Pimco suggests that the ultimate cost could be another $250 billion dollars on top of the $250-plus billion in subprime losses. That means we have only seen the tip of the iceberg in write-offs in the financial sector.

“The real problem is the ‘monoline insurers’ like ACA, Ambac, and MBIA. Here’s a quick primer on how they work. Let’s say you are a small municipality and want to borrow $10 million for a bond offering to build a road or a water treatment plant. If you went to the market with your credit rating, it would be a low rating and the cost of the money would be high. But if you get one of the seven monoline insurers to guarantee your bond, then you get whatever their credit rating is. The fees for such insurance are lower than the savings you get on the bond, so everyone wins.

“But over the years, most of the monocline insurers went from boring municipal bonds and jumped into the mortgage-backed security markets, selling credit default swaps that significantly juiced up their earnings. But it also added a lot of risk that they clearly, in hindsight, did not understand.

“ACA has already seen its rating go from A to CCC, which is basically junk. This puts it out of business, as no one will pay to be rated as junk. Merrill wrote down almost $2 billion in bonds that were insured by ACA. They will not be alone.

“Today, Fitch downgraded Ambac Financial Group two notches from AAA to AA. That doesn’t seem like a lot, until you realize that 74% of their revenue comes from that AAA rating that covers $556 billion in municipal and structured finance debt. Moody’s says it is going to review MBIA.

“If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss.

“If you have Ambac or MBIA insurance, as a bank you have not yet written down any debt they insured. They are still rated AAA. But that re-rating is coming. And what about the monster CDS business in the hedge fund world? There are going to be more losses in the biggest banks, and even bigger investments by Sovereign Wealth Funds. Count on it.”

Source: John Mauldin, Thoughts from the Frontline, January 18, 2008.

The Wall Street Journal: Citi makes an enticing offer
“Away from the headlines, Citigroup CEO Vikram Pandit quietly offered the great American public a deal this morning. Lend the bank some money, he said, and we’ll pay you a fat 7% interest rate. The payouts will get the same favorable tax treatment as shareholders’ dividends, but will be secure against pretty much anything except a full business meltdown. Oh, and if Citigroup’s fortunes recover you’ll get to share in the upside along with ordinary shareholders. That’s quite an offer.

“The bank is set to issue $2 billion worth of so-called convertible preferred stock to the public. The prospectus hasn’t been issued yet, but the terms should be similar to those offered to a handful of very rich investors in a just-concluded $12.5 billion private placement. Those investors include the bank’s former chairman, Sandy Weill, and Prince Alwaleed bin Talal. So if you buy into the convertible preferreds, you’ll be in good company.

“The stock will have a 7% yield. These are ‘preferred’ stocks, which means they’re a little like bonds. The dividends won’t rise: But they are pretty secure, as they should get paid in full before common shareholders get a penny. On the other hand, the dividends should get the same privileged tax treatment as payouts on shares. Oh, and investors will have the ability to swap their preferreds into ordinary shares if the price of the latter recovers 20% from its current depressed situation. In other words, you get a great yield, some pretty good security, and almost all the upside if things improve.”

Source: Brett Arends, The Wall Street Journal, January 15, 2008.

Ambrose Evans-Pritchard (Telegraph): Anna Schwartz blames Fed for subprime crisis
“As rebukes go in the close-knit world of central banking, few hurt as much as the scathing indictment of US Federal Reserve policy by Professor Anna Schwartz.

“The high priestess of US monetarism – a revered figure at the Fed – says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. ‘The new group at the Fed is not equal to the problem that faces it,’ she says, daring to utter a thought that fellow critics mostly utter sotto voce.

“‘They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence,’ she told The Sunday Telegraph. ‘There never would have been a subprime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for,’ she says.

“Schwartz remains defiantly lucid at 92. She still works every day at the National Bureau of Economic Research in New York, where she has toiled since 1941.”

Source: Ambrose Evans-Pritchard, Telegraph, January 14, 2008.

Bloomberg: Greenspan’s reputation at risk as recession odds grow
“The next bubble to deflate may be Alan Greenspan’s reputation. Hailed as perhaps the greatest central banker who ever lived when he left the Federal Reserve in 2006, Greenspan is under attack from critics ranging from the New York Times to economists at the American Enterprise Institute for his handling of the 2000-2005 housing boom. The former Fed chairman has taken to the media to defend himself, writing in the Wall Street Journal and appearing on network television.

“‘He’s had a bubble reputation that derived from the growth of US household wealth,’ said Edward Chancellor, author of ‘Devil Take the Hindmost: A History of Financial Speculation’. ‘As that goes down, his standing as a superstar will suffer.’

“At stake is not only Greenspan’s legacy but also the future of policies he espoused during 18-1/2 years atop the central bank. Critics blame his aversion to regulation and reluctance to use interest rates to puncture asset bubbles for the boom in mortgage lending and house prices that has since gone bust, threatening to throw the economy into recession.

“In an interview, Greenspan said such criticism ignores limits on what regulation and monetary policy can achieve.

“Fed Chairman Ben S. Bernanke has already moved away from the laissez-faire approach of his predecessor by proposing new restrictions on subprime mortgages.”

Source: Rich Miller, Bloomberg.com, January 10, 2008.

The Wall Street Journal: Trader made billions on subprime
“On Wall Street, the losers in the collapse of the housing market are legion. The biggest winner looks to be John Paulson, a little-known hedge fund manager who smelled trouble two years ago. Funds he runs were up $15 billion in 2007 on a spectacularly successful bet against the housing market. Mr. Paulson has reaped an estimated $3 billion to $4 billion for himself – believed to be the largest one-year payday in Wall Street history.

“Now, in another twist in financial history, Mr. Paulson is retaining as an adviser a man some blame for helping feed the housing-market bubble by keeping interest rates so low: former Federal Reserve Chairman Alan Greenspan.

“‘Most people told us house prices never go down on a national level, and that there had never been a default of an investment-grade-rated mortgage bond,’ Mr. Paulson says. ‘Mortgage experts were too caught up’ in the housing boom.

“In several interviews, Mr. Paulson made his first comments on how he made his historic coup. Merely holding a different opinion from the blundering herd wasn’t enough to produce huge profits. He also had to think up a technical way to bet against the housing and mortgage markets, given that, as he notes, ‘you can’t short houses.’

“Also key: Mr. Paulson didn’t turn bearish too early. Some close students of the housing market did just that, investing for a downturn years ago – only to suffer such painful losses waiting for a collapse that they finally unwound their bearish bets. Mr. Paulson, whose investment specialty lay elsewhere, turned his attention to the housing market more recently, and got bearish at just about the right time.

“Mr. Paulson has taken profits on some, but not most, of his bets. He remains a bear on housing, predicting it will take years for home prices to recover. He’s also betting against other parts of the economy, such as credit-card and auto loans. He tells investors ‘it’s still not too late’ to bet on economic troubles.

At the same time, he’s looking to the next turn in the cycle. In a recent investor presentation, he said his firm would at some point ‘start preparing’ for opportunities in troubled debt.”

Source: Gregory Zuckerman, The Wall Street Journal, January 15, 2008.

Richard Russell (Dow Theory Letters): Market shaping up as an angry bear
“Writing about the stock market or the economy is not a pleasant task at this time. The reason, of course, is losses, losses and more losses. When, on November 21, I wrote that we had witnessed a Dow Theory bear signal, I had no set idea as to what that bear signal portended or even the reasons the primary trend of the market had turned down.

“At the time, nothing seemed terribly out-of-kilter in the US economy. Sure, housing was a mess, but that had been well-publicized weeks, even months, in advance. And that’s the strange and damnable thing about the stock market. It speaks, it gives its rather rare Dow Theory ‘signals’, but at the time we never know exactly what it is that the market is telling us. But we don’t have to know – all we do have to know is UP from DOWN. At the time I didn’t know how important or how far ‘down’ was. And I’m still not sure about the full meaning of ‘down’ in the current situation.

“But it’s becoming rather clear to me that ‘down’ in this bear market means ‘down and dirty’. It’s ‘Katie bar the door.’ In other words, this bear market is not shaping up as anything vaguely pleasant. No, it’s shaping up as an angry grizzly bear. And this bear has been sinking his claws into the throats of investors, not only in the US, but around the world.”

Source: Richard Russell, Dow Theory Letters, January 16, 2008.

David Fuller (Fullermoney): Where will markets be in 12 months’ time?
“A considerable portion of the immediate problem is the temporary paralysis of the Western banking system. This is slowly being resolved but recapitalization takes time. Meanwhile, the losses are real and alarming, representing a shock to other sectors of the US and European economies, otherwise unaffected by the actual sub-prime related fiasco.

“Psychological problems for corporations, consumers and investors are considerable because a year ago very few people had even an inkling of what was about to happen. The outlook seems grim, or has certainly been made to look so by an excited and emotional press. Therefore, for perspective, we should refer to the table by DB Global Markets Research.

“The $400bn of losses forecast is insignificant compared to items in the table, not least DB’s calculation of $149.1trn for total world financial markets. However, the ongoing and more serious problem that has yet to be checked concerns confidence. The setback in stock market valuations since the sub-prime related problems broke is vastly greater than $400bn.

“Needless to say, governments and their central banks have a big vested interest in stopping the rot. This requires leadership, which has not exactly instilled confidence to date. However governments are crisis oriented and I assume that leadership in monetary, fiscal and psychological terms will improve over the next few months. This does not require a miracle – just common sense.

“A year from now, and perhaps well before, I believe calm will have returned to stock markets which will be trading above today’s levels … Meanwhile, most stock markets look as if they will move somewhat lower before they trend higher once again.”

Source: David Fuller, Fullermoney, January 15, 2008.

GaveKal: Equity markets approaching a bottom
“… much of the sell-off in equities around the world could be the result of some form of forced selling. While this could potentially persist a while longer, we note that equity markets are now massively oversold, and investor sentiment is about as bad as it can get (see graph). As such, we are hopeful that markets are approaching a bottom. As asserted by John Thain, Merrill’s write-downs could very well be ‘extremely conservative’ (and thus, future releases could turn out to be much better). Bernanke is sure to continue cutting rates. And the legislature sounds determined to deliver a big ‘stimulus package’. As such, while the risk of more selling (forced or not) remains, we are optimistic that markets will soon stabilize.”

Source: GaveKal – Checking the Boxes, January 18, 2008.

Mike Lenhoff (Brewin Dolphin Securities): Global equities looking oversold
“Global equity markets are looking oversold but should be in a much better position by the start of the second half, says Mike Lenhoff, chief strategist at Brewin Dolphin Securities. He says three points are worth considering.

“‘First, if the rate at which Citigroup has been prepared to make its writedowns is followed by other banks in similar positions … much, if not all, of the bad news relating to the subprime fallout could be flushed away – if not by the end of the first quarter, then by the summer.’

“Second, Mr Lenhoff says, US and UK interest rates will be very much lower by the summer. ‘Our view has been that the Fed funds rate will be down to 3.5 per cent by then and UK base rates down to 4.75 per cent, levels sufficiently low to induce expectations of better times ahead for the US and UK economies and an improving outlook for corporate earnings.’

“Third, valuations will start to look much more appealing when earnings are being upgraded, which Mr Lenhoff expects to happen when interest rates have been lowered.

“He says: ‘The major equity markets are oversold. That’s not much comfort if a bull market is breaking down. But the way I see it, this is a consolidation phase following four years of a bull market, and hence the transition phase to another leg of the bull market.’”

Source: Mike Lenhoff, Brewin Dolphin Securities (via Financial Times), January 16, 2008.

MarketWatch: Credit Suisse, in switch, recommends US stocks
“Credit Suisse strategists, for the first time this decade, recommended that fund managers buy more US stocks than a world index would suggest, saying that authorities state-side are likely to be quicker on the draw than their European counterparts in responding to the slowing economy.

“The strategists on Monday raised their rating on the US to 5% overweight, from benchmark.

“Strategists at HSBC made a similar call, raising their stance on the US to overweight while cutting their views on Europe and emerging markets to neutral.

“The Credit Suisse analysts pointed out the US Federal Reserve is one of the only central banks with a clear growth mandate. ‘Thus, we believe that the Fed will continue to be more balanced in its assessment of inflation risks,’ the strategists said, adding that labor-cost inflation and corporate-sector pricing trends both suggest underlying inflationary pressures are well contained.

“From a current level of 4.25%, the strategists said the Ben Bernanke-led Fed may slice the fed funds rate to as low as 3% by the end of the first half of 2008.

“‘By virtue of the weakening dollar and the Fed’s easing cycle, monetary conditions are now far looser in the US than in Europe,’ they noted. As for the housing market downturn, it said the US is up to two-thirds of the way through the downward adjustment.

“Where the strategists have turned negative is in Continental Europe: they cut the region’s rating to 10% underweight from benchmark. Unlike the Fed, the European Central Bank has an inflation-related mandate, and the hawkish comments made by ECB officials, including President Jean-Claude Trichet last week, suggest the ECB ‘could disappoint’ by keeping rates too high for too long.

“Of other regions, it kept Britain at benchmark, noting that domestic UK sectors are already pricing in something close to a hard landing; it kept its emerging-market overweight at 8%; and it moved its view on Japan to 10% underweight from 15% underweight.

“Credit Suisse bases its positions on the MSCI World Index, which has a 45% US weight, a 20.7% Europe weight, a 10.6% Asia ex-Japan weight, a 9.6% UK weight and an 8.6% Japan weight.

“Japan is now HSBC’s least favored market, because it’s the most cyclical, has least monetary room for cuts and new construction regulations won’t help. It cut Europe and emerging markets to neutral because of cyclical drawbacks.”

Source: Steve Goldstein, MarketWatch, January 14, 2008.

BCA Research: Take profits on long duration bond positions
“Valuation and other yardsticks argue that investors should trim bond duration to benchmark. The US and global slowdown has further to play out and credit market strains are likely to remain elevated for some time. Nonetheless, the government bond market rally is getting stretched, and we suggest taking profits on above-benchmark duration positions.

“First, our valuation models show that US and G7 10-year bond yields are trading near to the threshold of overvaluation. In the US, the real 10-year bond yield is at its lowest level since the 1970s. Moreover, the bond and money markets have already largely discounted a US recession. For example, eurodollars are priced for the fed funds rate to fall almost to zero in the next year. Similarly, investment-grade and junk corporate bond spread indexes are still below their 2002 peaks, but they too appear to be very close to recession territory.”

Source: BCA Research, January 17, 2008.

GaveKal: Remaining bullish on oil is a dangerous strategy
“… we think remaining structurally bullish on oil is … dangerous, given how far speculation seems to have drifted from sound fundamentals. Indeed, current prices are implying that 2008 will be the most bullish year ever for world growth (an assumption that is in stark contrast to the current bearish mood on growth). So what is going on?

“Current speculative fever centers on crude stock levels being at multi-year lows, and indeed they are. However, if we look at stocks of refined products, the picture is not as dramatic. The difference is accounted for by a slowdown in oil demand in the US – itself a function of price, seasonality and GDP growth. And herein lies the rub: With everyone and his uncle is calling for a recession in the US, official bodies keep lowering their energy demand growth estimates, and the industry is thereby left with little incentive to keep adding to stocks. In turn, low inventory numbers fuel speculation, and oil prices rise further – which discourages demand (as oil consumption does have some elasticity to price). Ironically, bold speculation (based on insufficient inventories) could further discourage oil demand at a very inopportune time …

“If the US falls into recession or simply slows down further this year, or if Europe enters a recession, or if Asia begins selling more of its production at home and shipping less across the Pacific, then demand for oil could drop dramatically. As we see it, these ‘ if’s’ are currently much more plausible than what oil is pricing in: a) a powerful surge in demand ahead, or b) a cataclysmic collapse in supply (while this risk is certainly still a concern, we note that production out of Iraq is now at a post-Saddam record high). All in all, we continue to believe that, for the oil price, the risks are far greater on the downside.”

Source: GaveKal – Checking the Boxes, January, 2008.

Michael Lewis (Deutsche Bank): Agricultural price rallies still in their infancy
“Michael Lewis, head of commodities research at Deutsche Bank, says rallies in the agricultural sector tend to be less pronounced and shorter in duration than upswings in the energy and metals sectors – which possibly reflects the faster supply response in agriculture compared with other parts of the commodity complex.

“The current rally in many agricultural commodity prices is still only close to historical averages in both magnitude and duration, Mr Lewis adds.

“But he says inventories in a number of agricultural products have fallen to critically low levels at a time when global demand for food, cattle feed and biofuels is rapidly increasing. ‘We consequently believe the price rallies in corn, cotton, soyabeans and wheat are still in their infancy.’”

Source: Michael Lewis, Deutsche Bank (via Financial Times), January 15, 2008.

BCA Research: China – tentative signs of growth moderation
“Chinese policymakers will stay in data-watching mode and are likely to tighten further. The most recent Chinese economic data, such as money supply and credit growth, have shown tentative signs of moderation. This is a positive development and suggests that the Chinese economy may have finally started to respond to policymakers’ escalating tightening measures. However, most macro indicators are still running far too hot for the authorities to take comfort.

“Looking forward, we expect that the tightening campaign will continue. With the reserve requirement ratio for commercial banks already at a record high and proving ineffective in an economy that is increasingly privatized, the authorities are likely to use interest rate and exchange rate policies more actively than in the past.”

Source: BCA Research, January 15, 2008.

GaveKal: Be cautious of Chinese equities
China is evermore determined to squash its rising price indices; and until it does, being cautious on Chinese equities (especially H-shares) might be wise …”

Source: GaveKal – Checking the Boxes, January 15, 2008.

Times Online: UK government’s court order plan to keep creditors at bay
“The Ministry of Justice announces the biggest shake-up in personal insolvency laws for years, which will permit borrowers to take a ‘repayment holiday’. Borrowers will be allowed to stop repaying debts by taking out a court order, under radical plans outlined yesterday by the government.

“The proposals would mark the biggest shake-up of personal insolvency legislation in years and come at a sensitive time for the financial services industry, which is bracing for an increase in consumer bad debts.

“The plans, which were outlined in a consultation paper yesterday by the Ministry of Justice, would allow consumers who fall into financial difficulties through a change of circumstance, such as losing their job or divorce, to stop making repayments on personal loans, credit cards and other debts for up to a year by applying for an ‘enforcement restriction order’.

“Bridget Prentice, the Civil Justice Minister, said: ‘We want to ensure that people who run up debts are given every opportunity to pay them off.’”

Source: Grainne Gilmore, Times Online, January 17, 2008.

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The past week witnessed mounting uncertainty as investors digested news regarding the ongoing credit market problems and deepening gloom about the global economy. In the words of Richard Russell, author of the 50-year old Dow Theory Letters: “If you’re standing on the railroad track and the train is bearing down on you at 90 miles per hour, don’t stand there trying to decide whether the oncoming train is the ‘Midnight Special’ or the ‘Wabash Cannon Ball’. Just get the hell off the tracks. Which train was coming at you can be determined later – right now that’s not the problem.”

In a speech on Thursday (January 10), Fed Chairman Ben Bernanke acknowledged a weaker economy and the need for further relaxation of monetary policy. He assured the American public at large, that the Fed would “take substantive additional action as needed to support growth and to provide adequate insurance against downside risks”.

However, this was cold comfort for The Street as Stock Trader’s Almanac pointed out that 11 of the last twelve easing periods have proved to be tumultuous times for the markets. It certainly does not inspire confidence when considering that the S&P 500 Index registered its worst performance on record (i.e. since 1950) for the first five trading days of 2008. Also, the fact that the Dow Jones Industrial Index closed below its December closing low (on January 2) and continues to trade below it, points to further weakness. Since 1950, 27 of 29 such occurrences saw continued declines with and average loss of 10.1%, according to Stock Trader’s Almanac.

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance chart.

Economy
Philadelphia Fed President Charles Plosser said on Friday (January 11) that the Fed’s biggest worry was potential weakness in consumer spending. Many investors fear that consumer weakness could push the US economy into a recession, a concern exacerbated by overall disappointing retail sales. Rising energy prices, weakening housing markets and slower job growth are all weighing heavily on consumer moods.

The annualized growth rate of the ECRI Weekly Leading Indicator continued on its way down, with Moody’s Economy.com remarking that the trajectory was increasingly looking similar to past periods preceding a recession.

With a barrage of economic data coming from all corners of the world, perhaps the more insightful information was the ECB and BOE decisions to leave their benchmark interest rates unchanged at respectively 4.0% and 5.5%. Although growth in the Eurozone is slowing, inflation remains of greater concern to central bankers than a slowdown in economic activity.

On the other hand, the US seems to be heading towards a half-percentage rate cut at the FOMC’s next meeting on January 30. Fed funds futures indicated an 88% chance of a 50 basis point rate cut, up from the pre-Bernanke speech level of 74%. Goldman Sachs sees three further rate cuts after January of 25 basis points each, bringing the Fed funds rate to 3.0% by mid-year.

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, January 11, 2007.

The next week’s economic highlights, courtesy of Northern Trust, include the following:

Markets
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week.

Source: Wall Street Journal Online, January 13, 2007.

Equities rallied on the back of Bernanke’s assurances, but it did not take long for subprime fears to resurface and most stock markets closed sharply lower on Friday. The MSCI World Index declined by 1.9% during the week, with Japanese stocks (-4.0%) falling to a 26-month low and European stocks (-2.4%) to a 13-month low.

Friday’s sell-off marked the third straight weekly decline for the US stock markets, with the Dow Jones Industrial Index suffering its steepest first-eight-sessions-of-the-year slide in 17 years.

The S&P 600 Small Cap Index (-2.8%) underperformed the larger caps of the S&P 500 Index (-0.8%). Defensive areas that are more resistant to an economic downturn, such as Pharmaceuticals (+3.3%) and Utilities (+1.5%), were among the few sectors registering positive returns for the week.

The depth of the problems faced as a result of the subprime fallout was underscored by Bank of America’s rescue of troubled mortgage lender Countrywide Financial, Merrill’s expected additional $15 billion write-down, and Citigroup’s second capital-raising effort ($14 billion) in as many months.

Government bond yields fell further around the world as the global economic outlook worsened and investors switched stocks to what is perceived to be a safe-haven asset class. However, fears that inflation could become a problem slowed the decline in long-dated maturities.

On the currency front, the US dollar fell somewhat against the euro as expectations of aggressive cuts in US rates increased. Worries about the deteriorating prospects for the UK economy resulted in the British pound hitting a record low against the euro.

The precious metals complex, however, was propelled higher by inflation jitters, with both gold ($898) and platinum ($1 564) recording all-time highs. Silver played catch-up and rose by 7.1% for the week compared with gold’s 3.8% and platinum’s 2.5%.

Base metals and agricultural commodities also performed strongly. A report by the US Department of Agriculture warned of extremely low inventories and pushed wheat prices to an all-time high, corn prices to an 11-year high and soyabean prices to a 34-year high.

Now for a few news items and some words (and graphs) from the investment wise that will hopefully assist to make sense of financial markets’ shenanigans during the week ahead.

Source: Steve Sack, Slate, January 8, 2008.

Moody’s Economy.com: Survey of business confidence for world
“US business confidence fell to a new record low at the start of 2008 and is consistent with recession. Sentiment is stronger elsewhere across the globe, particularly in Asia, although it is down everywhere since the subprime financial shock began this past summer. Expectations regarding the first half of 2008 are especially bleak, plunging to another new low last week. Businesses have also become notably cautious with respect to their inventories and office space needs. Hiring and fixed investment are soft, but holding up better. Pricing pressures have risen with oil prices near $100 per barrel, but remain very subdued compared to the pressures that prevailed during previous oil price spurts.”

Source: Moody’s Economy.com, January 7, 2008.

BCA Research: Global economy – the oil tax
“The surge in oil prices toward the US$100 threshold adds to growth risks for many of the world’s economies. At US$100 per barrel of WTI, the world’s oil bill will approach US$3 trillion, equivalent to roughly 5% of GDP. That would mark a 1% increase compared with last year and comes at a time when growth in the advanced economies is already moderating in response to the US housing collapse and tightening credit conditions. US consumers in particular will feel the pinch, increasing downside risks for the American economy.

“While strong oil demand – especially in China and the Middle East – is contributing to the surge in crude prices, the rising world oil bill is bearish for global growth. This ‘tax’ on growth adds to pressure for major central banks to ease monetary policy. While rising oil prices have temporarily push up headline inflation, the impact of crude on price pressures may already be peaking. Bottom line: High oil prices will require more aggressive stimulus from policymakers in order to support economic growth.”

Source: BCA Research, January 7, 2008.

James Quinn (Telegraph): US recession is already here, warns Merrill
“The US has entered its first full-blown economic recession in 16 years, according to investment bank Merrill Lynch. Merrill, itself one of Wall Street’s biggest casualties of the sub-prime crisis, is the first major bank to declare that a recession in the world’s biggest economy is now underway.

“David Rosenberg, the bank’s chief North American economist, argues that a weakening employment picture and declining retail sales signal the economy has tipped into its first month of recession. Mr Rosenberg, who is well-respected on Wall Street, argues: ‘According to our analysis, this [recession] isn’t even a forecast any more but is a present day reality.’

“His comments are the strongest sign yet that the gloom on Wall Street over the US economy is deepening as the sub-prime mortgage crisis and the credit rout show little sign of easing.

“Mr Rosenberg points to a whole batch of negative data to support his analysis, including the four key barometers used by the National Bureau of Economic Research (NEBR) – employment, real personal income, industrial production, and real sales activity in retail and manufacturing. … he believes that all four of these barometers ‘seem to have peaked around the November-December period, strongly suggesting that we are actually into the first month of a recession.’”

Source: James Quinn, Telegraph, January 8, 2008.

Ambrose Evans-Pritchard (Telegraph): Bush convenes Plunge Protection Team
“Bears beware. The New Deal of 2008 is in the works. The US Treasury is about to shower households with rebate cheques to head off a full-blown slump, and save the Bush presidency. On Friday, Mr Bush convened the so-called Plunge Protection Team for its first known meeting in the Oval Office. The black arts unit – officially the President’s Working Group on Financial Markets – was created after the 1987 crash.

“It appears to have powers to support the markets in a crisis with a host of instruments, mostly by through buying futures contracts on the stock indexes and key credit levers. And it has the means to fry ‘short’ traders in the hottest of oils.

“The team is led by Treasury chief Hank Paulson, ex-Goldman Sachs, a man with a nose for market psychology, and includes Fed chairman Ben Bernanke and the key exchange regulators.

“Judging by a well-briefed report in the Washington Post, a mood of deep alarm has taken hold in the upper echelons of the administration. ‘What everyone’s looking at is what is the fastest way to get money out there,’ said a Bush aide. Emergency measures are now clearly on the agenda, apparently consisting of a mix of tax cuts for businesses and bungs for consumers.

“‘In terms of any stimulus package, we’re considering all options,’ said Mr Bush. This should be interesting to watch. The president is not one for half measures. He has already shown in Iraq and on biofuels that he will pursue policies a l’outrance once he gets the bit between his teeth.”

Source: Ambrose Evans-Pritchard, Telegraph, January 8, 2008.

Asha Bangalore (Northern Trust): FOMC is ready to ease monetary policy 50 basis points
“Chairman Bernanke was crystal clear about the near term direction of monetary policy when he concluded his remarks with the following: ‘However, in light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary. The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.’

“These transparent comments have raised the probability of a 50 bps cut in the federal funds on January 30 to a nearly certain situation and movements in the federal funds futures market reflect this scenario.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 10, 2008.

Reuters: Goldman, JP Morgan sees Fed cutting 50 basis points
“A sputtering job market has convinced economists at key US investment banks that the Federal Reserve will need to resort to a steeper half-percentage point interest rate cut when it meets later this month. Both Goldman Sachs and JP Morgan said on Friday they now see the Fed slashing the benchmark federal funds rate down to 3.75% from the current 4.25%, with Goldman also considering the possibility of an intermeeting move.

“Goldman sees three further rate cuts after January, of 25 basis points each, bringing the fed funds rate to 3.00% by mid-year. JP Morgan expects a 25 basis point rate cut in March. It also revised its growth forecasts – raising fourth-quarter 2007 growth to 2% from 1.5% while lowering first quarter growth to zero from 1%.

“The Fed already has cut the fed funds rate by a full percentage point since mid-September as policy-makers aimed to soften the blow to the US economy of a slumping housing sector and a global tightening of credit conditions.”

Source: Tamawa Kadoya and Pedro Nicolaci da Costa, Reuters, January 4, 2008.

The Wall Street Journal: Paul Kasriel – housing prices to fall sharply

“Northern Trust chief economist Paul Kasriel, recalling the Seinfeld ‘Festivus’ episode, airs some grievances in his latest commentary, particularly noting the ridiculous valuations houses have in relation to consumer income. Between 1980 and 2000, the price of a house averaged about 337% of consumer income, but that rose to 469% in the 2000-2006 period. In order to reestablish the old equilibrium, he notes that housing prices would need to fall 22% – but the median price of an existing home has not declined on a year-over-year basis between 1968 to 2006, ‘so, we are in uncharted waters here,’ he writes.”

Source: David Gaffen, The Wall Street Journal, December 17, 2007.

Bloomberg: Default risk rising strongly
“The risk of companies defaulting rose the most in more than two months this week after US reports showing a slowdown in jobs growth and manufacturing stoked concern that the economy will sink into a recession.

“Defaults may rise almost seven-fold to 2.25 percent this year, analysts at New York-based JPMorgan Chase & Co., the biggest underwriter of high-yield, high-risk corporate bonds last year, said in a report yesterday.

“The US economy is ‘very close’ to recession, ‘if not there already,’ Bill Gross, who manages the world’s largest bond fund as PIMCO’s chief investment officer, said in an interview on Bloomberg Television.”

Source: Kabir Chibber and Shannon D. Harrington, Bloomberg, January 4, 2008.

The Wall Street Journal (via GATA): Citigroup, Merrill seek more foreign capital infusions
“Two of the biggest names on Wall Street are going hat in hand, again, to foreign investors. Citigroup and Merrill Lynch, two companies that just named new chief executives after being burned by the troubles in the US housing market, recently raised billions of dollars from outside investors. Now they are in discussions to get additional infusions of capital from investors, primarily foreign governments.

“Merrill is expected to get $3 billion to $4 billion, much of it from a Middle Eastern government investment fund. Citi could get as much as $10 billion, likely all from foreign governments.

“Such large investments would be the latest sign big banks are undergoing a rapid recapitalization to stabilize their shaky financial foundations. Already, foreign governments have invested about $27 billion in Merrill, Citi, UBS and Morgan Stanley.

“Both Citi and Merrill are scrambling to nail down the details before they report earnings next week that are expected to include additional losses stemming from their exposure to mortgage-related investments. Together, these additional losses could reach as much as $25 billion.”

Source: David Enrich, Randall Smith, and Damian Paletta, The Wall Street Journal (via GATA), January 10, 2008

Bill King (The King Report): Too big to bail
“Our view is that the current financial imbroglio is so massive that ‘too big to fail’ will become ‘too big to bail’. There is no conceivable way to bailout entities that might entail trillions of dollars.”

Source: Bill King, The King Report, January 7, 2008.

Financial Times: Moody’s says spending threatens US rating
“The US is at risk of losing its top-notch triple-A credit rating within a decade unless it takes radical action to curb soaring healthcare and social security spending, Moody’s, the credit rating agency, said on Thursday (January 10, 2008).

“The warning over the future of the triple-A rating – granted to US government debt since it was first assessed in 1917 – reflects growing concerns over the country’s ability to retain its financial and economic supremacy.

“Most analysts expect future governments to deal with the costs of healthcare and social security and there is no reflection of any long-term concern about the US financial health in the value of its debt.

“But Moody’s warning comes at a time when US confidence in its economic prowess has been challenged by the rising threat of a recession, a weak dollar and the credit crunch.”

Source: Francesco Guerrera, Aline van Duyn and Daniel Pimlott, Financial Times, January 10, 2008.

John Hussman (Hussman Funds): Minding the hinges on Pandora’s Box
“The stock market is oversold short-term, which invites the potential for a spectacular ‘clearing rally’ of the typical variety – fast, furious, and prone to failure. While such an upward spike might be embraced as some sort of message that the market has ‘fully discounted’ negative conditions and mark a successful ‘test’ of prior lows, the data suggest that underlying market and economic conditions are rapidly deteriorating. In that context, a spectacular short-term rally (particularly a one-day barn burner) could provide a setup for concerted selling. As usual, I have no intention of encouraging investors to depart from well constructed investment plans, but investors should recognize that a 30% market decline is only a standard run-of-the-mill bear. It’s a good idea to evaluate your investment portfolio to ensure you could tolerate that outcome, should it occur, without abandoning your discipline.

“The expectation of oncoming recession may be gaining some amount of sponsorship, but it is still far from the consensus view, and is therefore most probably far from being fully discounted in stock prices. In short, if the potential negatives such as profit margin contraction and credit problems turn out to be only passing, minor events, then it might be true that the market has fully discounted them. However, my impression is that the scope of these problems is likely to be much broader than anticipated at present, and that the combination of worsening outcomes and a growing consensus could result in substantially more weakness than we’ve observed thus far.

“Though P/E multiples have come down a bit, they are still very rich on the basis of normalized profit margins. The notion that rich valuations on record profit margins can be overlooked, and will not be followed by sub-par long-term returns, is a speculative idea that runs counter to all historical evidence.

“On the issue of whether the recent correction removes any further potential for market weakness, Jim Stack of Investech notes that prolonged correction-less periods have generally been resolved by much deeper losses than 10%. At 55 months, the period since 2003 has been the second-longest stretch in 80 years without a 10% correction. The record was the 84-month period during the 1990’s. Though that instance ultimately led to a series of 10-18% corrections between 1997 and 2000 before the market finally dropped in half, the other most prolonged periods (40 months from Oct 1962 – Feb 1966, and 37 months from Jul 1984 – Aug 1987) were followed immediately by full bear markets.”

Source: John Hussman, Hussman Funds, January 7, 2008.

Richard Russell (Dow Theory Letters): Primary stock market trend has turned down
“The operative thesis for investors at this time is that the primary trend has turned down. A bear market is in progress. What does this mean? I’ve outlined this many times before, but here goes again – the position I favor here is cash and gold, a lot of gold. You can buy GLD, you can buy gold coins, and you can also buy GDX, which represents a list of gold mining shares. The important thing is to have a good position in all things golden.

“I don’t know how far this bear market is fated to carry. Nor do I know how long it will last. My advice – be prepared for the worst and hope for the best. To hope costs you nothing, but to be unprepared can cost you much, maybe more than you can imagine at what probably is this early phase of the bear market.

“Through over half a century of experience, I’ve learned to respect bear markets. I don’t trade them, I don’t fade them, I don’t short them – I stay out of them. I’ve learned to stay on the sidelines.”

Source: Richard Russell, Dow Theory Letters, January 9 & 11, 2008.

Bill King (The King Report): Corporate earnings in negative territory
“S&P 500 Q3 y/y earnings growth declined 4.3%. Expectations were +4% at the beginning of Q3. This is the lowest quarterly growth rate for the S&P 500 since Q1 2002.
“What is astounding about the S&P 500 earnings decline is that it’s with 4.9% GDP growth!!! Obviously something is not kosher with that GDP number. And what will happen to earnings in a recession?!”

Source: Bill King, The King Report, January 11, 2008.

Ben Abelson (Resource Investor): Staying afloat in a sea of red
“Anyone who has been paying a lick of attention to the world at large should be rightfully concerned about the health of their financial portfolios. While market watchers loudly proclaim that 2008 will be another ‘strong year’ for domestic equities and mainstream economists downplay the risk of recession, the economic reality observable by the man on the street is quite clearly troubling.

“For anyone who has any industry experience in the mortgage markets or leveraged finance (this correspondent included) it’s quite clear that the excesses of the past several years will take significant time to work off – and will strongly impact the ‘real’ economy in the process.

“While there are certainly some bears rumbling at the periphery, much of the Wall Street selling machine continues to call for ‘double-digit gains’ in 2008, often touting the market’s relatively undervalued P/E ratio. Looking at this one (often useless) measurement alone, however, reveals much to be concerned about. While the market’s backward looking P/E is certainly relatively low, any prognosticator who uses this as a reason to invest is overlooking one crucial point: After normalizing profit margins only to historical averages, the ‘E’ portion of the ratio sinks quite dramatically, making the markets look much less favourable. When one factors in (and extrapolates) the type of losses currently being seen from all major financial institutions these days (which make up approximately 20% of the S&P 500), the picture is considerably more bleak.

“Investment bank economists also continue to tout the ‘underlying’ strength of the domestic economy. But economics isn’t called the ‘dismal science’ without reason. While economic common sense is immensely valuable in explaining how and why individuals and firms make rational business decisions, many economic prognosticators have a woeful track record in predicting future events. Given that the entire field is often predicated on the usage of backward-looking indicators and data – rather than common sense future observations/predictions – this isn’t terribly surprising.”

Source: Ben Abelson, Resource Investor.com, January 7, 2008.

Financial Times: Gold is the new global currency
“There was a time when gold was money. In today’s uncertain world, the yellow metal is back in fashion. Bullion prices rose to a record nominal high after the assassination of Benazir Bhutto in Pakistan added to nervousness about the world economy. Part of gold’s allure is its traditional status as a safe haven. It is seen as a store of value when everything else seems risky. But the bigger drivers behind the rising spot price are a depreciating dollar and the prospect of negative US real interest rates.

“A better way to think of gold may be as central bankers used to before America dropped the gold standard: not as a commodity, but as another currency. As long as the dollar stays weak, gold’s bull run will last.

“The arguments for further gains in the gold price are compelling. It looks cheap, despite climbing from a low of about $250 a troy ounce in 1999, when central banks were selling reserves. The UK’s decision back then to sell 60 per cent of its official holdings looks particularly poor judgment.

Gold is … benefiting from diversification away from equities. Commodities have emerged as a distinct asset class, with billions of dollars poured into exchange traded funds. Physical demand for jewellery may have stalled in Asia, but consumption remains strong in the Middle East. Declining output in South Africa will help support spot prices.

“But it is the relationship between the dollar and the reaction of the world’s central banks to the credit squeeze that some bulls would say really makes gold an attractive bet. The US Federal Reserve’s aggressive, rate-cutting response to the credit squeeze has created a risk of a sharp rise in American inflation. That in turn creates the risk of a precipitous fall in the dollar and so makes gold more attractive as a hedge.

“The world’s major economies have experienced rapid money supply growth of 10 per cent plus per annum in recent years. The Fed remains the world’s biggest holder of gold, yet supplies of the metal are no longer growing annually. If gold is a finite currency, its value against not just the dollar, but sterling and the euro too, should rise.

“Moreover, a sharp decline in US real interest rates – financial markets expect another half percentage point cut this month – means that the low yield on gold matters less. It may have been a poor hedge against inflation in the past but the combination of rising consumer prices and economic stagnation may make it a better store of value.”

Source: Financial Times, January 7, 2008.

Richard Russell (Dow Theory Letters): Gold is a bargain
“What can I buy today at 1979-1980 prices? Russell, you’ve got to be kidding. Everything is much more expensive today. Forget those prices of 1979-1980. Get into reality, man.

“Wait, there is one thing that I can buy today at around 1979-1980 prices. That one thing is gold. Gold today is selling just a bit higher than it sold for back in January 1980. How can that be? Brother, it be. Today you can buy gold for just a few percentages more than gold sold for at its high in January 1980.

“‘Hey Russell, does that mean that gold is a bargain?’ My answer is that I don’t think of gold in terms of it being bargain-priced, I simply think of it as real money that is catching up to the times. I can’t buy the Dow at its 1980 price of 850. Hardly, the Dow is selling at 14 times its 1980 prices. Well then, how is it that gold is still under 900? That’s a long story, but let’s just say that I really don’t know. I do know that gold is underpriced compared with almost anything else. So yeah, when I think about it, yes, gold is a bargain. And I like bargains – particularly when the bargain happens to be real money.”

Source: Richard Russell, Dow Theory Letters, January 10, 2008.

David Fuller (Fullermoney): Gold’s advance may pause for a while
“My only concern at the moment is that everyone is talking about gold, including bullish forecasts aplenty. I think they are right but sentiment is often a contrary indicator so gold’s advance may pause for a while.”

Source: David Fuller, Fullermoney, January 7, 2008.

John Hussman (Hussman Funds): Market climate extremely favorable for precious metals
“In precious metals, the market climate appears extremely favorable, featuring downward yield trends, upward inflation trends (and in combination, a very hostile environment for the US dollar), economic weakness evidenced by a weak ISM Purchasing Managers Index among other factors, and a gold/XAU ratio that is well above 4. This combination of conditions has historically generated an unusually strong return/risk profile for precious metals shares.”

Source: John Hussman, Hussman Funds, January 7, 2008.

GaveKal: Ideal environment for gold
“Gold has been an exceptional play, having risen +36% since mid-August. Of course, this marks the period in which the credit crunch drove the Fed to cut its discount rate, join the ECB in a series of liquidity injections, and begin stepping down the Fed Funds rate. However, these were not the only factors at play. The past six months has provided the ideal environment for gold:

1. Demand from Asia was on the rise;
2. Demand from the Middle East was also on the rise;
3. Real rates around the globe were fairly low;
4. And then came the credit crunch and the housing bust; and
5. Fears of currency debasement have escalated.

“Indeed, when it seems like things cannot get any better, they often do not. And, for example, if China were to really liberalize its capital markets, gold prices could lose a lot of steam. However, until something significant knocks off this surge in demand, it is hard to see gold retreating.”

Source: GaveKal – Checking the Boxes, January 9, 2008.

Financial Post: Forget oil, the new global crisis is food
“A new crisis is emerging, a global food catastrophe that will reach further and be more crippling than anything the world has ever seen. The credit crunch and the reverberations of soaring oil prices around the world will pale in comparison to what is about to transpire, Donald Coxe, global portfolio strategist at BMO Financial Group said …

“‘It’s not a matter of if, but when,’ he warned investors. ‘It’s going to hit this year hard.’

“Mr. Coxe said the sharp rise in raw food prices in the past year will intensify in the next few years amid increased demand for meat and dairy products from the growing middle classes of countries such as China and India as well as heavy demand from the biofuels industry.

“’The greatest challenge to the world is not US$100 oil; it’s getting enough food so that the new middle class can eat the way our middle class does, and that means we’ve got to expand food output dramatically,’ he said.”

Source: Alia McMullen, Financial Post, January 7, 2008.

Richard Spencer (Telegraph): China is quietly revaluing the yuan
“The People’s Bank of China may at last be substantially revaluing its currency – even if officially it has told no-one. Dramatic changes in recent months and especially the last week in the crawling dollar peg the central bank sets for the renminbi (RMB) are leading to big cumulative shifts in its rate.

“The changes this month alone would see a 15%-16% hike on an annualised basis, and markets are starting to estimate that the gain may be as much as 9% over the year. That would bring the total change since the government abandoned the fixed peg in July 2005 to nearly 20%.

“The move may have striking repercussions for a global economy in which China’s currency policies have often come under fire for creating liquidity imbalances, but which is now also fighting the threat of higher prices.

“Most analysts say fear of domestic inflation is the prime reason for a policy change. The consumer prices index rose 6.9% in November, up from 6.5%, despite government hopes that inflation had peaked. It blamed big rises in food prices, but there are also signs that inflation is creeping into the wider economy.”

Source: Richard Spencer, Telegraph, January 9, 2008.

David Fuller (Fullermoney): China’s and India’s stock markets attractive for long term
“I have often referred to China and India as the king and queen of emerging markets, for their current and especially long-term growth potential. China’s A-Share valuations, which the government has gently deflated somewhat since the peak, reflect not only earnings growth but also China’s high savings rate and very limited access to other stock markets. India’s appeal is also earnings growth, which is currently seen as more secure since exports account for only 15% of GDP. In theory, the Indian economy is less susceptible to the US economic slowdown.

“My view is that China’s and India’s stock markets will inevitably be volatile from time to, for all the usual reasons, but remain extremely attractive for the long term. I have no intention of reducing my holdings in these markets but have often said that I prefer to buy following setbacks. Currently, of the two this only applies to China.”

Source: David Fuller, Fullermoney, January 10, 2008.

Bloomberg: Goldman says Japan recession risk at ‘danger level’
“Goldman Sachs cut its economic growth estimate for Japan and said there’s a 50% chance of a recession in the world’s second-largest economy.

“‘The probability of a recession in Japan has risen to the danger level,’ Tetsufumi Yamakawa, chief Japan economist at Goldman, said in a report to clients today. ‘We project weaker- than-expected growth in Japan.’

“The nation’s economy will continue to slow ‘for the time being,’ Bank of Japan Deputy Governor Toshiro Muto said today. The housing slump in the US, which Goldman yesterday said may already be in recession, could prompt overseas investors to sell real estate holdings in Japan, Credit Suisse Group said today.

“Yamakawa cut his 2008 growth estimate to 1 percent from 1.2 percent, citing slower demand from emerging markets. Sluggish spending by consumers has left Japan more dependant on overseas markets, just as cooling US demand threatens to spread to Asia, where Japan sells half its exports.”

Source: Jason Clenfield, Bloomberg.com, January 10, 2008.

BCA Research: Euro area slowdown will continue
“The euro area economy is likely to expand by roughly 1.5% in 2008 versus trend growth of slightly over 2%. Growth in the euro area is starting to downshift rapidly on the back of historically tight monetary conditions.

“Export growth is slowing, business activity and sentiment measures have eroded markedly and our industrial production model warns of a sharp deceleration in the coming months. On the domestic demand front, spending remains lackluster but stable employment conditions and high levels of accumulated savings should prevent a significant deceleration.

“The ECB will be slow to ease but below trend growth should erode inflation pressures in the coming months and help alleviate concerns of policymakers, opening the door to rate cuts by the end of the first half of 2008.”

Source: BCA Research, January 8, 2008.

GaveKal: Europe is heading for a recession
“Last month, we again made the case for a European recession, citing three reasons why we expect Europe to face even bigger economic problems in this coming year than the US, namely:

“Today, it seems the cracks are finally starting to show in Europe. France just posted a record trade deficit of -€4.8 billion, as exports dropped by -1.8% in November. And with sales to the US and Asia declining, the French Finance Minister is promising to push for a weaker Euro at next month’s Group of Seven meeting. And she may get support from her German counterpart, as German exports also dropped -0.5% MoM in November, while industrial production fell -0.9% MoM.

“What is perhaps even more telling is the fact that European retail sales have already started to falter. In Germany, for example, retail sales fell -3.2% YoY in November, and then Christmas shopping failed to match last year’s levels. And this comes while the Euro is still extremely strong and labor markets are still relatively tight (German unemployment fell from 8.6% in November to 8.4% in December – this may be high by US standards, but it represents Germany’s lowest reading since 1993.

“We are now evermore convinced that Europe is heading for recession. And to make matters worse, Europe does not excel at making the necessary adjustments at such transition points in the business cycle.

“All in all, we see troubling times ahead for European markets.”

Source: GaveKal – Checking the Boxes, January 10, 2008.

Moody’s Economy.com: UK Halifax Housing Price Index
“Growth in the average house price, as calculated from the mortgage portfolio of HBOS, rose 1.3% (seasonally adjusted) in December, though on a year ago basis, price growth slipped to 5.2%. The monthly figures represent the first positive rate of month-ago growth since August, when prices grew 0.3%. In that month, the year ago rate stood at 11.4%. Overall, the data continue to point to a softening in house-price growth in the UK and follow a downwardly revised contraction of -1.3% m/m in November.”

Source: Moody’s Economy.com, January 8, 2008.

Reuters: UK property development slowdown deepens
“Property development work shrank for a second month in December, posting its biggest fall in at least four years and 9 months as tumbling commercial property values hit builder sentiment, data showed on Friday.

“In a monthly survey, property services firm Savills said commercial developers were also pessimistic on average about the outlook for work in the first three months of 2008, despite last month’s cut in the Bank of England base rate.

“‘While tenant demand has stayed steady, it is evident that the combination of the credit squeeze and falling capital values is affecting developers’ sentiment,’ Mat Oakley, head of Savill’s commercial research, said.”

Source: Paul Bolding, Reuters.com, January 11, 2008.

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“Winter, spring, summer or fall, all you have to do is call, and I’ll be there, you’ve got a friend …” These are the lyrics of Carol King’s song. Yes, as life swings from boom to gloom it is the support of friends that often provide the necessary solace.

It is unlikely that Mr Market will come patting you on the back when your investments go pear-shaped, but he does provide his own unique variety of comradeship. In an environment cluttered with noise, Mr Market offers us the very simple but true adage of “the trend is your friend”. This sounds comforting enough, but Mr Market still expects us to fulfill a task: to identify the direction of the trend.

An important point to realize is that there are trends within trends, varying from ultra short (intra-daily) to short (daily) to intermediate (weekly) to long term (monthly). Although day traders play short-term trends from minute to minute, I believe that it is really the identification of the primary (multi-year) trends that holds the key to successful investing.

One way of approaching this is to gauge the fundamental landscape – factors such as unfavorable valuations, stretched profit margins, mounting evidence of an imminent recession and increasing default risk. These paint a fairly bleak picture, but keep in mind the discounting nature of the stock market, having already factored in the gloomy news we are faced with 24/7. In order for the market to fall further the nature of the problems should turn out to be broader and deeper than currently discounted. As mentioned previously, I believe that the fallout of the housing and subprime situation has not been fully discounted.

A more visual way of recognizing the primary trend is by means of analyzing the technical picture, especially using a longer-term perspective.

The following graph indicates how the Dow Jones Industrial Index has been mapping out a series of lower lows and fallen below its 200-day moving average (often seen as an indicator of the primary trend). The shorter term 50-day moving average is trending down and provides an early indicator of what is in store for the longer-term average. The Index has just dropped below its November low on increased volume, serving as further confirmation of a downtrend.

Source: StockCharts.com

The chart below shows the percentage of stocks on the NYSE that are trading above their 200-day moving averages. As of yesterday’s close the reading was 28.1%. This is the lowest reading in five years and indicates that more than seven out of every 10 stocks are in primary downtrends. Although the current level appears low, the number has fallen as low as 10% at previous bear market bottoms (such as 2002).

Source: StockCharts.com

Next is the 10-year graph of the NYSE Composite Index (based on monthly data), indicating the price trend together with the MACD oscillator. The failed year-end rally in December witnessed the histograms falling below the zero line (see blue circle) for the first time since the start of the bull market in 2003. (The previous MACD sell signal was given eight-and-a-half years ago in July 1999.)

Source: StockCharts.com

Turning to a monthly graph of the Dow Jones Industrial Index, a similar picture emerges when using the 14-month RSI oscillator. This indicator is overbought at levels above 70 and oversold below 30. The RSI’s trend is now falling for the first time since the bull market commenced in 2003.

Source: StockCharts.com

My assessment of the above is that there is more weakness for the stock market ahead. Although the market is oversold on a short-term basis, I would be very reluctant to take long positions in the face of what I believe is a market topping out and embarking on a primary downtrend. I therefore concur with Nouriel Roubini, professor of economics at New York University, when he says: “… a lousy stock market in 2007 will look good compared to an awful stock market in 2008.”

I wrote a series of bearish articles on the stock market (and bullish on gold) during the latter months of 2007 of which the last one on December 17 was entitled “Is this the end of the stock market party?”. Mr Market has provided the answer and it is a rather discomforting one. Yes, “the trend is your friend”, but only if you heed Mr Market’s warnings and appreciate that the stock market is in a downtrend. Be inordinately cautious with your investment strategy.

Source: Unknown

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The hot financial topic of discussion at the moment is the likelihood of a US economic recession. Against the background of a deteriorating economic landscape, it is not surprising that more and more commentators have started declaring that a recession was either already underway or just around the corner.

A noteworthy contribution to this debate has just been offered by Asha Bangalore, economist of Northern Trust. Her analysis deals specifically with the movements of the S&P 500 Index just prior to and during a recession. The leading/lagging properties of the Index, and by how much it changes during a recession, are summarized in the table below.

S&P 500 Index – peaks and troughs

Two major conclusions follow from Bangalore’s research:

By the close of the market yesterday the S&P 500 Index was down by 9.5% from its peak in October 2007. Although the expectation of a recession has been gaining support, it does not represent a consensus view by a long shot. Using Bangalore’s analysis of the historical relationship between the stock market and economic cycle as a guide, a rough ride could be in store in the months ahead.

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A trading week made up of a bit of the old year and a bit of the new caused some anxiety in financial markets as economic woes escalated and weighed on investor sentiment. The problems related to the housing market and the subprime implosion seemed to be coming to a head. After all, the Dow Jones Industrial Index recorded its worst three-day start to a New Year year since the depths of depression in 1932, according to Barron’s.

Stock markets were left in the shade as both gold and oil hit all-time highs. Nouriel Roubini, professor of economics at New York University, wrote on his blog: “… the stock market started the year with another bearish fall … a lousy stock market in 2007 will look good compared to an awful stock market in 2008.”

Santa Claus failed to call upon the traders on Wall Street. The “Santa Claus Rally”, as defined in the Stock Trader’s Almanac, is the propensity for the S&P 500 Index to rally during the last five trading days of December and the first two of January. This year’s Rally saw the S&P 500 Index down 2.5% and the Dow Jones Industrial Index (-2.9%) and the Nasdaq Composite Index (-3.3%) were not spared either.

It is pointed out by the Stock Trader’s Almanac that the lack of a rally had often been “a harbinger of a sizable correction or a bear market in the coming year.” Hence the saying: “If Santa Claus should fail to call; bears may come to Broad & Wall.”

John Mauldin, author of the Thoughts from the Frontline newsletter, is also of the opinion that the equities bull market may finally succumb in 2008, and said in his 2008 forecast: “I think that we are in a recession for most of the first half of this year, and that we begin a slow recovery in the second half. It will be a Muddle Through Economy for at least another year after that. That would suggest that most companies will come under serious earnings pressure. If history is any indicator, that means we should see a bear market in the first half of this year. How deep will depend on how fast the Fed cuts, but I don’t think we are looking at anything close to the bear market of 2000-2001. Still, I wouldn’t want to stand in front of a bear market train.”

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance chart.

Economy
The past week’s economic reports fueled concerns about the spillover effect of the subprime crisis leading to an economic recession.

The much anticipated US employment report on Friday, which showed weaker-than-expected job growth and a rise in the unemployment rate, compounded investors’ worries.

According to the Institute for Supply Management, national manufacturing activity shrank unexpectedly in December. Specifically, the ISM Index fell to 47.7 from 50.8 in November – a reading below 50 indicates a contraction in manufacturing activity.

These reports provide strong support for further Fed easing. An interest rate cut of 25 basis points at the FOMC’s next meeting on January 30 seems a foregone conclusion, but the Fed Fund futures now also indicate a 46% chance of a 50 basis point reduction. “There are those who hope that the Fed will ride to the rescue with more rate cuts. I believe they will, but it is a case of ‘too little, too late’,” remarked John Mauldin.

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, January 4, 2007.

The next week’s economic highlights, courtesy of Northern Trust, include the following:

Markets
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week.

Source: Wall Street Journal Online, January 6, 2007.

As this article deals only with the past week’s performance, a separate performance review of 2007’s market movements was posted on the blog last week. This round-up makes for interesting reading and also provides pointers of what to expect in the year ahead. Please click here for full the article.

Global stock markets began the year on shaky ground, trading lower during the past week amid escalating concerns about the fallout in the housing and credit markets. The MSCI World Index lost 3.2% during the course of the week, but a number of emerging markets helped to stem the overall losses.

The US markets were at the forefront of the sell-off with the blue-chip Dow Jones Industrial Index losing 4.2%, the broader S&P 500 Index 4.5% and the technology-heavy Nasdaq Composite Index 6.3%. Small caps and the sectors for REITS, financials, housing and consumer discretionary spending, in particular, were not spared the selling pressure.

Government bond yields declined in both developed and emerging markets as the global economic outlook worsened and investors switched stocks to what is perceived to be a safe-haven asset class.

On the currency front, the US dollar came under renewed pressure as markets started pricing in the possibility of the Fed reducing interest rates by 50 basis points at the end of January. Concerns about the deteriorating prospects for the UK economy resulted in the British pound recording a four-year low against the euro.

The star performers among the major currencies were the Japanese yen (+4.1%) and Swiss Franc (+2.0%) as increased risk aversion resulted in unwinding of carry trades. The Chinese yuan also caught the limelight on the back of its uptrend (as reported in the “quotes section” below).

Commodities were the big winners during the past week as investors piled into oil and precious metals.

Crude oil hit a record level of $100 a barrel early in the New Year, but subsequently eased back somewhat. Factors driving the oil price included a weaker dollar, geo-political tensions over the Middle East and supply concerns.

The gold price also reached a record high during the past week, soaring above the $850 an ounce level last achieved in January 1980. In addition to the factors driving the oil price, gold benefited strongly from mounting inflation jitters.

Agricultural commodities again put in a strong performance and gained 3.6% during the week.

This week promises to be a key week for the direction of financial markets. Hopefully the words (and graphs) from the investment wise below will assist in guiding us through the stormy waters and making the correct investment decisions. But firstly, to cheer you up, here is nature’s way of saying “have a nice day!”.

Hat tip: Jim Sinclair’s Mineset

Financial Times (Alphaville): Marc Faber – when surrounded by rubbish and danger, buy gold
“‘The credit bubble is just beginning to unwind, and while US borrowers are being blamed for the mess, they were really just a pawn in a global game.’ So says Marc Faber, aka Dr Doom.

“In the New Year issue of his Gloomboomdoom.com monthly market commentary for subscribers, Faber muses darkly on the direction of the US economy, markets, bond insurers and Wall Street banks, and concludes – as he has increasingly in the past months – that gold, among other commodities, is a very good place to put your money.

In the US, the severity of the housing recession is evident from the record level of existing home inventories as a percentage of US households, he notes. ‘It should therefore, only be a matter of time until housing starts decline further and will also signal the onset of a recession.’

“He sets out three key observations:

“Emerging stock markets are definitely to be avoided, he adds, ‘following their significant out-performance over the last few years’.

“So, where would Dr Doom put his money? He likes sugar, cotton and he still recommends accumulating gold, which he expects to continue to out-perform equities for several years. Still, nothing goes up in a straight line, notes Faber, and, therefore, investors need to be aware that gold could still correct to around $750 or so.’

“In Faber’s opinion, ‘the gold bull market will come to an end when Sovereign Wealth Funds – sick and tired of their investments in financial stocks – will finally purchase gold – probably at above $3,000 per ounce.’”

Source: Gwen Robinson. Financial Times – Alphaville, January 3, 2008.

Richard Russell (Dow Theory Letters): Stock market’s primary trend turning down
“Question – Russell, you’ve been talking about a third phase to the stock market. Where are you now on this subject?

“Answer – As you know, I’m guided at all times by the action of the stock market itself. When the market doesn’t agree with me, I stop, revise my thinking – and get in harmony with the market. Which is what I’ve been doing over recent weeks.

“Something has interrupted the major rising trend of the market. It’s not a little thing, no, it’s something very big, very powerful, very basic. Frankly, I don’t know what it is. Could it be that the dollar is in serious trouble? Could it be that the US economy is in chronic trouble? Could it be that the US consumer is finally throwing in the towel on spending? Could it be that the real estate situation is a lot worse than we think? Could it be that the situation is so major that it is beyond the Fed’s ability to manipulate? I don’t know, I honestly don’t know.

“But I do know one thing. The primary trend, the great tide of the stock market, appears to be in the process of turning down.”

Source: Richard Russell, Dow Theory Letters, January 4, 2008.

Asha Bangalore (Northern Trust): Weakness in US labor market points to recession
“The civilian unemployment rate rose to 5.0% in December from 4.7% in November. The December reading is the highest since September 2005. The jobless rate has now risen from a cycle low of 4.4% in March 2007. The increase in the unemployment rate reflects a widespread loss of jobs … Historically, sharp increases in the unemployment rate are associated with recessions.”

Note: Shaded areas denote recessions.
Source: Bureau of Labor Statistics /Haver Analytics

Unemployment Rate and Recessions

“Payroll employment rose only 18 000 in December, the smallest gain since August 2003. Revisions to October and November payroll estimates show a net gain of 10,000 jobs. Private sector payroll employment fell 13 000 in December, the first monthly record of private sector job losses since July 2003. Total payroll employment increases averaged 111 000 per month in 2007 versus a 189 000 per month in 2006. On a year-to-year basis, total payroll employment slowed to a 0.9% gain, down from a peak growth rate of 2.14% in March 2006. Household survey data also show a similar decelerating trend in hiring.”

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 4, 2008.

Moody’s Economy.com: US ISM Index – manufacturing activity contracting
“Manufacturing activity contracted in December with the ISM index falling 3.1 points to 47.7. This marks the sixth consecutive decline in the index, the last time this occurred was between 2000 and 2001. Also, the latest decline puts the ISM below its expansionary threshold of 50 for the first time since January. With business confidence fragile and uncertainty surrounding the economic outlook growing, it is clear that manufacturers are letting final demand set the pace of production. Today’s report provides additional support for further Fed easing.”

Source: Moody’s Economy.com, January 2, 2008.

Moody’s Economy.com: US MBA Mortgage Applications Survey – mortgage demand depressed
“Mortgage demand decreased 11.6% in the week ending December 28. Purchase applications decreased 8.5% and refinance applications decreased 15.4%. Another week of declining activity suggests improving conditions in the nation’s housing market are still not in sight.”

Source: Moody’s Economy.com, January 3, 2008.

Wall Street Journal Online: US home prices must fall far to be in sync with rents
“US house prices would have to fall considerably to return to a normal relationship with rents, says a study by one former and two current Federal Reserve economists. The study … suggests prices would have to fall 15% over five years, assuming rents rose 4% a year. House prices would have to fall further if the adjustment took place more quickly.

“The study tracks rents and home prices back to 1960 and found annual rents fluctuated at around 5% to 5.25% of home prices until 1995. At the end of that year, the average monthly rent was about $553 (or about $6 600 a year) and the average home price was about $134 000. But starting in 1996, home prices started to grow much more rapidly than rents. By the end of 2006, they had more than doubled to an average of $282 000, while the average rent had risen 48% to $818. That drove the annual rent/price ratio down to 3.48%.

“That means the rent/price ratio is about a third below its long-term average. To return to normal would require some combination of falling prices and rising rents. The paper suggests house prices would need to fall about 3% a year, if rents grew in line with their 4% average annual growth this decade.”

Source: Greg Ip, Wall Street Journal Online, January 3, 2008.

Nouriel Roubini (RGE Monitor): US recession now unavoidable
“As expected … a US recession is now unavoidable … The combination of the worst housing recession ever getting worse, a severe liquidity and credit crunch being worse now than in August, oil close to $100, capex spending by the corporate sector falling for four months now, commercial real estate being in serious trouble, the labor market beginning its slack (as initial claims and continuing claims are surging), and a shopped-out, saving-less and debt-burdened consumer having stopped its shopping spree this holiday season will all lead to a severe – rather than mild – recession in 2008.

“According to Bill Gross this recession may have already started in December 2007; when eventually the NBER business cycle dating committee will date (in the next 12 months) the peak of this business cycle December 2007 may indeed end up being the beginning of this recession or, at the latest, Q1 of 2008.”

Source: Nouriel Roubini, RGE Monitor, January 2, 2008.

Paul Kasriel and Asha Bangalore (Northern Trust): Fed Monetary Policy – 50-50 for 50; 99-1 for 25
“The December employment report confirms expectations of further easing of monetary policy. A 25 basis point cut in the federal funds rate to 4.00% on January 30 is nearly certain; a more aggressive 50 basis point cut is an even bet in our view.

“The ISM manufacturing survey indicates a contracting factory sector to go along with a contracting housing sector. The marginal increase in auto sales in December appears to be fleeting given soft hiring conditions. Weakness in the labor market is also supported by the latest employment surveys such as the Manpower Survey, Monster Employment Index, and Hudson Employment Index and jobless claims data.

“The nature of recent economic reports has raised the probability of a recession. The FOMC voting-member hawks, Philadelphia Fed President Plosser and Dallas Fed President Fisher, will try to limit the reduction in the fed funds target to only 25 basis points by arguing that the past year’s run-up in food and energy prices and the run-down in the foreign exchange value of the dollar are clear and present inflation dangers. However, FOMC voting-member doves might counter with the argument that inflation is a lagging economic process and that a severe recession is the clearer and more present danger.”

Source: Paul Kasriel and Asha Bangalore, Northern Trust – Daily Global Commentary, January 4, 2008.

Bloomberg: Bush to meet with Treasury about economic stimulus package
“President George W. Bush will meet with Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke tomorrow as he considers whether to announce a new economic stimulus package amid slowing growth.

“Bush will speak to reporters tomorrow after a 1 p.m. meeting at the White House with members of the President’s Working Group on Financial Markets, press secretary Dana Perino said today.

“‘It will be a number of weeks before the president makes a decision’ on a stimulus package, White House spokesman Tony Fratto said. ‘There will be some additional data coming in the next few weeks, and the president has said he won’t make any decisions until it gets much closer to the State of the Union’ address on Jan. 28.

“The meeting tomorrow will come hours after the Labor Department’s December employment figures, which economists anticipate will show a weaker pace of job gains and higher unemployment. Reports in the past week showed a contraction in manufacturing and the weakest new home sales in 12 years.

“The administration ‘will do what we think is appropriate to continue to foster economic growth,’ Ed Gillespie, senior counselor to the president, told reporters Jan. 1. ‘There’s more to be done, we think, on the housing front to address concerns people have.’”

Source: Roger Runningen and Holly Rosenkrantz, Bloomberg, January 3, 2008.

Moody’s Economy.com: Survey of business confidence for world
“Global business sentiment ended 2007 weak and fragile. It fell sharply with last summer’s subprime financial shock and has never recovered. US businesses are particularly on edge; American confidence is consistent with a contracting economy. Expectations regarding the first half of 2008 are especially bleak, falling to a record low last week on a 4-week moving average basis. Pricing pressures have risen with oil prices near $100 per barrel, but remain very subdued compared to the pressures that prevailed during previous oil price spurts.”

Source: Moody’s Economy.com, December 31, 2007.

Bloomberg: Central bankers risk inflation to extend growth party
“Ben S. Bernanke, Mervyn King and fellow central bankers may go on filling up the world economy’s punch bowl in 2008, even at the risk of an inflationary hangover.

“Signs that the party is ending for global growth are keeping monetary policy leaning in the same direction at major central banks, with those in the UK and Canada likely to join Bernanke’s Federal Reserve in cutting interest rates again. The same conditions may lead the European Central Bank and the Bank of Japan, which shelved plans for raising rates, to remain on hold for months.

“‘I expect 2008 to mark the beginning of another global liquidity cycle,’ says Joachim Fels, Morgan Stanley’s London-based co-chief economist. ‘More signs of slowdown or even recession are likely to swing the balance towards more aggressive monetary easing in the advanced economies.’”

Source: Simon Kennedy, Bloomberg, January 3, 2008.

Reuters: Gloomy prospects for UK housing market for 2008
“Signs have been mounting of a slowdown in Britain’s property market, so what are the prospects for 2008?

“A total 1.4 million people will see their fixed rate mortgage deal end in the early part of next year, and each will be forced to pay an average of 200 pounds per month more to meet the cost of servicing their home loans.

“Tighter lending conditions could add pain to consumers already mortgaged to the hilt – outstanding housing debt stands at more than a trillion pounds – and household finances look set to be stretched further by rising food and energy costs, as wages fail to keep pace with inflation. This will lead to a record 130 000 people being declared insolvent during 2008, according to accountant KPMG, and financial woes, say some experts, will severely dent consumer confidence and exacerbate the housing market slowdown following a period of record growth.

“House prices have risen 179 percent over the past 10 years from an average price of 70 000 pounds in late 1997.”

Source: Jennifer Hill, Reuters, December 29, 2007.

Wall Street Journal Online: Oil hits $100 – jolting markets
“The surging price of oil, from just over $10 a barrel a decade ago to $100 yesterday, is altering the wealth and influence of nations and industries around the world. These power shifts will only widen if prices keep climbing, as many analysts predict. Costly oil already is forcing sweeping changes in the airline and auto sectors. It is intensifying the politics of climate change and adding urgency to the search both for fresh sources of crude and for oil alternatives once deemed fringe.

“The long oil-price boom is posing wrenching challenges for the world’s poorest nations, while enriching and emboldening producers in the Middle East, Russia and Venezuela. Their increasing muscle has a flip side: a decline of US clout in many parts of the world. Steep gasoline prices also threaten America’s long love affair with the automobile, while putting strains on many lower-income people outside big cities, who must spend an increasing share of their budgets just on fuel to get to work.

“No one can say for sure whether sky-high oil – part of a price boom in a wide range of commodities, from gold to wheat – is here to stay. But most in the industry agree that a 20-year stretch in which oil was consistently cheap is long gone. The global thirst for oil shows little sign of retreating, and large new discoveries are few.

“The arrival of $100-a-barrel oil adds to the pressure on the US economy, which has sustained a big blow from a drop in housing prices and a wave of foreclosures. Even at today’s prices, though, the oil spike alone isn’t enough to push the world into recession, economists say.”

Source: Neil King Jr, Chip Cummins and Russell Gold, Wall Street Journal Online Online, January 3, 2008.

Ambrose Evans-Pritchard (The Telegraph): Bullion outshines record from 1980
“Gold has soared through resistance to touch an all-time high of $861.20 an ounce in New York, surpassing the record last seen at the height of the inflation crisis in 1980.

“Bulls seized the initiative as oil spiked briefly to $100 a barrel and the dollar buckled on bad manufacturing data in the US. The New Year surge – setting the tone for the year – may be viewed with some ‘alarm by central banks, aware that gold often serves as a proxy for inflation fears.

“Ross Norman, director of TheBullionDesk.com, said the world faces a new era of ‘peak gold’ in which discoveries become rarer, leaving the market starved of the metal just as demand in China and emerging Asia begins to gather pace. ‘Supply is declining despite a seven-year bull run,’ he said. ‘Production in South Africa is the lowest since the 1930s, and it is falling in Canada. As for the central banks, they are no longer quite so keen to part with their gold.’

“‘New conduits such as ETFs have opened up, giving investors access to a market that used to be off radar. It has led to a slow, glacial flow of big money into gold that is immune to profit taking. On January 9, China will start trading gold futures in Shanghai,’ he said.

“Mr Norman, the top forecaster for the London Bullion Market Association over the past four years, said gold would reach $1 200 an ounce this year. Veteran gold traders say the metal is enjoying a perfect storm of inflation fears, geo-strategic jitters over Pakistan and mounting concerns that the dollar could lose its role as anchor of the international currency system as Mid-East and Asian states break their dollar pegs.”

Source: Ambrose Evans-Pritchard, The Telegraph, January 3, 2008.

Richard Russell (Dow Theory Letters): A mighty interesting move coming up for gold
“Now that gold is at all-time highs, is there any way to tell where gold might be going? I’m going to repeat the words of W.D. Gann. Mr. Gann is considered by many professionals to have been one of the greatest commodity and stock traders (and thinkers) of all time. Here are Gann’s words (courtesy of my old New York friend, Ron Rosen).

“‘When a stock or a commodity advances into new territory or to prices which it has not reached for months or years, it shows that the force or driving power is working in that direction. It is the same principle as any other force which has been restrained and breaks out. Water may be held back by a dam, but if it breaks through the dam, you would know that it would continue downward until it reaches another dam, or some obstruction or resistance which would stop it.

“‘Therefore, it is very important to watch old levels of stocks and commodities. The longer the time that elapses between the breaking into new territory, the greater the move you can expect, because the accumulative energy over a long period naturally will produce larger movements than if it only accumulated during a short period of time.’

“It took 28 years for gold to break out above it’s 1980 high of 850. In view of what Gann says, this should be a mighty interesting move coming up for gold.”

Source: Richard Russell, Dow Theory Letters, January 3, 2008.

David Fuller (Fullermoney): Gold is in a secular bull market
“A continuing refrain heard over the last many years is that: ‘Gold is not doing what it is supposed to do’, whatever that means. Gold’s value is in the eye of the beholder. Therefore sentiment will wax and wane, just as it does for any other market.

“Consequently, a mantra at Fullermoney is that gold and its sister precious metals are best purchased following setbacks. Psychologically, this is not easy because the chart action may raise concerns and sentiment will have deteriorated.

“Gold’s new all-time (numerical) high today, in USD and most other currencies, is just a minor step within the overall upward trend. Its main significance is that it reaffirms the uptrend. It may also improve sentiment and another momentum run is possible.
“I maintain that gold is in a secular bull market … not least because in this era of ultra competitive pressures from globalisation, no country wants a strong currency. However some countries need a weak currency more than others, and these include the US.”

Source: David Fuller, Fullermoney, January 2, 2008.

CS Monitor: Why the era of cheap food is over
“Food prices worldwide hit record highs in 2007, and all the signs are that they will go on rising this year, and for the foreseeable future. The era of cheap food, the experts say, is over and we are going to have to get used to it.

“What is behind the increases in food prices?

“Two major trends have been pushing prices up faster than they have risen for more than 30 years. One is that increasingly prosperous consumers in India and China are not only eating more food but eating more meat. Animals have to be fed (grains, usually) before they are butchered. The other is that more and more crops – from corn to palm nuts – are being used to make biofuels instead of feeding people.

“At the same time, the world is drawing down its stockpiles of cereal and dairy products, which makes markets nervous and prices volatile. The result, says Joachim von Braun, who heads the International Food Policy Research Institute (IFPRI) in Washington, is that ‘the world food system is in trouble. The situation has not been this much of a concern for 15 years.’”

Source: Peter Ford, CS Monitor, December 31, 2007.

Eoin Treacy (Fullermoney): No evidence that commodity bull market is over
“Industrial metals have been in a corrective phase for much of the year (2007) with nickel and zinc in particular posting significant declines, but the longer-term demand story, for these and almost all other commodities hasn’t changed at all. Asian infrastructure and consumer growth remain some of the most powerful elements affecting commodity markets and this is set to continue for a number of years yet. Some metals remain at relatively depressed levels; although they firmed recently, Precious metals are setting new highs as are a number of agriculturals. I see no evidence that this commodity bull market is over.”

Source: Eoin Treacy, Fullermoney, January 4, 2008.

BCA Research: Emerging market decoupling to continue in 2008
“Emerging markets have weathered the US credit market calamity very well and the bull run will continue in 2008.

“The economic decoupling between emerging economies and the US is attributable to underlying fundamentals and is therefore sustainable. Unlike in the 1990s when emerging economies relied on foreign capital to finance their expansion, many of these countries are now net creditors in global financial markets and are not vulnerable to a withdrawal of financing by G7 banks. Domestic interest rates are still very stimulative thanks to their strong currencies and vast savings, which will continue to underpin domestic demand growth. While exports to the US have been slowing, trade among developing economies is booming. As a result, overall emerging market growth will not slow considerably, even if the US economic slump continues. Bottom line: We recommend that investors continue to overweight emerging equity markets within a global portfolio.”

Source: BCA Research, January 3, 2008.

Bill Cara: China lets currency appreciate faster
“Thanks to a surge in recent weeks, China’s yuan is set to end 2007 up nearly 7% against the dollar – twice the amount it appreciated against the US currency in 2006 – and economists forecast a similar pace of upward movement in 2008. That could help cool down the red-hot growth in the world’s third-largest economy.

“Some analysts see the apparent policy shift as a sign of confidence. One reason the government seems more willing to move now is that Chinese exporters are so far surviving the effects of pinched profit margins resulting from the pricier Chinese currency – important because maintaining jobs in the huge export sector is a priority of China’s leadership.

“The accelerated movement against the dollar also appears to be driven by several concerns that a stronger currency could help address: inflation running at its highest rate in 11 years, a current-account surplus that soared to 12% of gross domestic product in the first half of 2007, and ballooning valuations on Chinese stock markets. Even so, there is little indication that the yuan’s rise has satisfied US politicians, manufacturers or workers, who have complained for years that China is unfairly boosting exports by manipulating the currency.”

Source: Bill Cara, December 31, 2007 (text); and Fullermoney (graph).

David Fuller (Fullermoney): Yuan is significantly undervalued
“I maintain that the yuan is a significantly undervalued currency. Therefore its long-term appreciation potential is considerable. This will increase China’s global purchasing power. At some point within the next 20 years, I assume that the yuan will become fully convertible. That would usher in a new era, including reserve currency status.”

Source: David Fuller, Fullermoney, January 2, 2008.

Bloomberg: US dollar’s share of currency reserves falls
“The dollar’s share of global foreign-exchange reserves fell to a record low in the third quarter as demand for US assets waned after the subprime-mortgage market collapsed. The dollar accounted for 63.8% of reserves at the end of September, down from 65% three months earlier, the International Monetary Fund said today in Washington. The euro’s share rose to 26.4% from 25.5%.

“The figures suggest central banks diversified out of the dollar as it fell to the lowest level in a decade. Investors sold a record amount of US securities in August when defaults on subprime mortgages rippled through financial markets and the Federal Reserve signaled it would cut interest rates.

“‘The dollar seems to be losing, at least to some small extent, its favored status,” said David Powell, a currency strategist at IDEAglobal in New York. “Foreign central banks aren’t necessarily shunning dollar assets, but they were more attracted to other currencies.’

“China, Russia and other countries with trade surpluses or rising energy-export earnings are setting up so-called sovereign wealth funds to increase earnings on their reserves. Speculation also intensified in the third quarter that Saudi Arabia, United Arab Emirates and other Middle Eastern nations would follow Kuwait and end their currencies’ pegs to the dollar.”

Source: Christopher Swann and Kevin Carmichael, Bloomberg, December 28, 2007.

Thomas Jefferson: Banking establishments
“I sincerely believe … that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale.”

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2007 ended with a nasty hangover in the case of some asset classes and stock market sectors, but also with pockets of splendid performance. Reviewing the past year’s investment returns makes for interesting reading, but also provides guidelines in some instances of what to expect in the year ahead.

In order to glean the macro view of what transpired last year, it is useful to consider the performance of the principal asset classes as a point of departure. I have deliberately kept the commentary rather brief as the detailed reasons for specific movements have already been covered in my weekly “Words from the Wise” article.  

Source: Stockcharts.com

Commodities (+16.7%), in general, were the top-performing asset class, followed by the US 10-Year Treasury Note (+4.9%) and the S&P 500 Index (+3.5%). A money market investment, based on the average US 3-Month T-Bill rate, would have yielded a return of 4.4% – somewhat better than the S&P 500 Index (but less than the Dow Jones Industrial Index and the Nasdaq Composite Index as shown later in the article).

The other side of the coin saw the Dow Jones REIT Index declining by 19.2% and the US Dollar Index by 8.4%. The dollar weakness was naturally one of the factors contributing to the strength in commodities.

Interestingly, the performance table changed around quite dramatically during July 2007 as the subprime problems started to surface, resulting in an acceleration of the US dollar’s downtrend and large-scale switching from stocks to bonds and commodities.  

Source: Stockcharts.com

Zooming in on stock markets, the chart below shows the Dow Jones World Index gaining 8.4% during 2007. Top-notch performance was achieved by emerging markets (+28.8%), and specifically by China (+110.1%), India (+69.4%) and Hong Kong (+39.4%). On the other end of the spectrum, Japanese stocks (-5.5%) were in the doldrums and experienced losses.

As far as the major US stock markets are concerned, the blue-chip Dow Jones Industrial Index gained 6.4% – somewhat better than the S&P 500 Index’s 3.5%, but behind the technology-heavy Nasdaq Composite Index’s respectable 9.8%. US small caps, as represented by the Russell 2000 Index, fared poorly in the light of being more sensitive to an economic slowdown and depreciated by 2.8%.

Click here for the detailed performance figures, ranging from one month to three years, for 55 global stock markets.

Looking in some more detail at the various US stock market sectors, seven out of the nine sector SPDRs recorded gains, whereas the Consumer Discretionary SPDR (-14.0%) and Financial SPDR (-20.0%) were the big losers. This weakness was offset by Energy (+36.1%), Materials (+21.5%), Utilities (+17.0%) and Technology (+15.4%), resulting in the major US indexes still ending the year in positive territory.  

Source: Stockcharts.com

The stark difference in performance between the diamonds and dogs are illustrated clearly by the graph below comparing two of the top-performing industries – Oil Services (+50.9%) and Gold & Silver (+21.8%) – with three of the worst casualties – Housing (-38.9%), Banks (-24.6%) and Retail (-17.9%). The subprime fallout, needless to say, stands largely to blame for this dismal performance.

Source: Stockcharts.com

The credit crunch resulted in interest rates declining across the spectrum of the yield curve but to a larger extent on the short end, resulting in a steepening yield curve as shown in the diagram below. As the credit situation deteriorated, safe-haven buying resulted in yields of government bonds being pushed down across the globe. 

Source: Stockcharts.com

The US dollar’s downward trend intensified as the implications of the subprime debacle started to unfold, resulting in the US Dollar Index losing 8.4% during the course of 2007. The largest beneficiary of the dollar’s woes was the euro with a gain of 10.6%.

Source: Stockcharts.com

On the commodities front, oil (+52.3%) was the star performer on the back of a tight demand/supply situation and omnipresent geopolitical tension. Agricultural commodities (+41.1%) also shined as producers battled to keep up with increasing demand.  

The precious metals complex benefited from the Fed’s easier money policy and mounting concerns about rising inflation. Industrial metals, however, were the odd one out and faced declining prices as investors started factoring in slower economic growth.

Source: Stockcharts.com

The overriding message of the above analysis is the strong emphasis on defensive asset classes and sectors. There also does not seem to be any indication of last year’s primary trends reversing as we enter 2008, although some of 2007’s laggards may bottom out during the course of this year.

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