The week ahead

I'll be on vacation the next couple of weeks, so I probably won't update nightly.

Friday was pretty much as expected. I thought maybe if we broke below 884 that we'd see a leg down, but overall it was a bullish day. Up volume was larger than down volume and advancers were ahead of decliners. Considering it was quadruple witching, it was a lot more bullish than it may have felt. We didn't get any momemtum on the upside, but the downside had no strength either.

I've been doing a lot of reading about recessions, depressions and economic history lately. A quick observation is that the Fed is doing everything it ought to be doing if it is concerned about the risk of a deflation. Another way to say that is that the Fed is (a) very concerned that a real risk of a deflationary depressions exists and (b) doing everything they can to avoid it, regardless of the impact on the future. That's the fundamental flaw and the reason why it will ultimately fail - if they somehow manage to increase borrowing in light of declining economic conditions, then the borrowing will be at lower and lower quality, creating an ever-greater problem to deal with at the next downturn. They know this, too, which tells me that we have already started a deflationary cycle and they are doing the best they can to reverse it before it becomes obvious to everyone.

I raise these points simply to provide a backdrop for trading over the next weeks and months. Optimism has not be completely sucked out of the system. Quite the contrary, in fact. So, over the coming weeks, I would expect to see a steady run in the S&P to the 950 range. The inauguration seems the perfect event to create a peak in optimism.

Businesses, however, have already made up their mind. These days, they make their decisions on fear and survival, and no interference from the Fed is going to stop the layoffs, cost cuts and factory closures. So, by the time we get to March, when the inauguration is a distant memory, we'll be mired in bad news and more and more signs of deflation. Once optimisim takes a breather, we'll have to go down to new lows.

Think about it this way: when the rally was about to end in the late '90's, the Treasury removed capital requirements from banks (this is the regulation that we've heard about on TV that became lax). This temporarily encouraged more lending (to riskier debtors, since all the lower-risk debtors already had their loans). And the banks loaned until they were up to whatever max they could muster. Any dent in credit quality would set off a spiral for them, which we have seen. It really wouldn't have mattered if it was mortgages, or corporate debt, or margin accounts. The banks were on the razor's edge and slipped. So, now the Fed has lowered rates to effectively zero (can't be more pro-lending than that) and also given them capital to do it with. These capital infusions are actually, effectively, negative capital requirements for the banks. That is, the banks are now encouraged to lend money that isn't theirs to start with. If the banks continue to be unwilling to extend credit, or unable given the probability for payback, what can the Fed do next? They can start mopping up the bad assets, but that is with our tax dollars, so we'll pay for that. We might soften the bottom of this credit bust, but it will just make another one necessary.

When you see mandates that require the banks to lend money, put all your cash in a pillowcase. We've all figured out what went wrong (lending money to people who couldn't afford to pay it back). Once the government starts mandating lending at minimum levels for banks, that's your sign that there is nothing left for them to do, and, even if it "works," it won't take long for it to backfire just like it did with mortgages. Only next time, we'll see the Fed and Treasury not as our saviors, but as the problem itself. And everyone will catch on and attempt to get ahead of the credit contraction cycle. It'll happen so fast if we get to that point that the markets will go down to levels that no one has dared utter up to this point.

Best case, the Fed creates a soft landing, a regular recession, and then has to reckon with it's actions, which will be a governor on growth for the next 10 or 20 years, which will be a period of successive recessions set off every time the Fed attempts to recoup some of it's "investment." And this will likely be the subject of the vilification of the Fed and Treasury as things unwind next year. If they knew the best they could offer was serial recessions for the next 10-20 years, why didn't they just allow the deflation to run it's course, and then start to dabble two years into the cycle to facilitate the recovery?

Joe