Stock Market -- Fundamental Landscape Part 1

Let me start with the liquidity cycle. I can tell you
straight off that there is no prior period in the modern
era that comes very close to matching this one. We are
thus in an environment with unusual elements. Short term
interest rates are falling and broad, credit driven
liquidity is barely growing (1.0% over the past six months).
This is unusual, but not unprecedented. What is new, is that
even with a weakening economy, the Fed is maintaining a very
tight rein on the growth of monetary liquidity. So, although
the price of credit is falling, liquidity remains scarce.
Through its TAF, the Fed has bought $50 billion of crummy
quality bank paper, but it has had the FOMC drain the
markets of a nearly comparable amount of Treasuries and repos.
It is trying through the TAF and lower rates to coax the
credit markets back to life. There has been some success, but
progress remains slow and the process is fragile.

By holding back on infusions of liquidity into the banking
system, the Fed is still seeking to contain commodities driven
inflation pressures, but in doing so, it is keeping the economy
at considerable risk. The message to me is that further
economic weakness short term is tolerable to the Fed if it
results in breaking the uptrend in commodities prices where there
is strong speculative interest. Some Wall St. guys like Jim Cramer
may well see the Fed as composed of loosely hinged academics who
are testing academic suppositions at the expense of the real
world.

The risk here is that if economic weakness intensifies short term,
lenders will grow even more risk averse, and there will be an
acceleration of "downcycling" to the detriment of the economy. This
would, in turn, force the Fed to slash rates further and pour
liquidity into the system. But, if the lower rates work now to coax
borrowers in, and the banks use their new flexibility to fund more
and provide more credit, well then, the plan might work. It is all
in the timing, as they say.

The lead economic indicators are still trending down and are consistent
with the development of an economic downturn. A downturn may not yet
be "a lock" but the indicators are moving that way. There is some
evidence that inflation pressures may be easing, and such easing could
become more pronounced if the economy develops more slack.

There is substantial economic uncertainty here and a fair measure of
downside risk. Bernanke is running a significant gamble,and if
commodities prices do not crack over the next month or two, he may
be forced to re-think it.

The stock market has started to price in a recession and not just a
sharp slowdown, preferring to think the Fed's gamble may well fail.

More on this landscape issue in the days ahead.