Prices rise but we get that sinking feeling…

Terrible news on both the economy and banking system sent stocks tumbling this week.

Among the economic reports, U.S. retail sales declined for the sixth month in a row. Oil demand is weak, and inventories continue to mount. Last week's unemployment numbers for December were grim. So are the economic headlines from Europe and Japan.

Of greater concern for future growth prospects is the bad news coming out of the banking sector. Most of the headlines involve Citigroup and Bank of America, but other bank stocks in the U.S. and Europe are down sharply too.

Citigroup is expected to soon announce big losses, and it clearly needs more capital, even after receiving $45 billion in government help last November. At today's low, its shares were down 91 percent from their high and 43 percent over the last five days alone. There is speculation that the U.S. will have to take over Citigroup, whose Robert Rubin is finally resigning after many years of huge compensation with little to show for it—in addition to denying any responsibility for Citigroup's meltdown.

The U.S. government is close to a deal that would give billions in additional aid to Bank of America to help it close its acquisition of Merrill Lynch. Reason: Larger-than-expected losses at Merrill. BAC shares were down 85 percent from their high and 43 percent over the last five days.

Unfortunately, the massive greed, incompetence and neglect of many financial leaders will make it harder for the economy to rebound. Here's why.

Because of their huge losses, the big banks need capital, both to meet regulatory requirements and to encourage them to lend. Lacking capital, they have less ability and willingness to create credit, which is necessary to loosen the economy and foster growth.

The estimate of losses from loans in the hands of banks and other lenders is running as high as $2 trillion. Estimating loan losses precisely is impossible. And the numbers vary with what happens to the economy, prices of homes, commercial real estate and other assets, and various assumptions. But the number has been growing, and it poses a formidable obstacle to a sustained recovery.

It's generally agreed that financial institutions still have a long way to go in fully recognizing and writing off their losses. When banks or other financial institutions recognize a loss, it depletes capital. And when their share prices fall, it makes it harder for them to raise new capital. 

But the Stimulus Will Help…

Details of President-elect Barack Obama's economic-stimulus package, currently estimated at $825 billion, were released today. It's the largest economic stimulus legislation ever put forward by the federal government, in an all-out effort to deal with what is likely the deepest economic downturn since the Great Depression.

The plan calls for $275 billion in tax cuts and $550 billion in spending, including $90 billion for infrastructure projects. Whatever form the package eventually takes, the earliest it's currently expected to be signed into law is mid-February.

Once the plan is passed and whatever its pros and cons, it will follow the TroubledAsset Relief Program (TARP) and moves by the Federal Reserve in working through the economy. The positive impact of this massive economic stimulus should show up in a significant way starting in the second quarter.

Meanwhile, we have already seen some improvement in the credit market. The TED spread, the premium banks pay for loans compared to the U.S. government’s borrowing cost, is now at a 5-month low, and the LIBOR, a measure of short-term rates, is near its lowest since 2003. Mortgage rates are coming down. And the corporate and municipal bond markets are acting well.

Don't forget that the Federal Reserve has effectively cut rates to almost zero, and the monetary base has doubled in the last year, with no signs of slowing yet.

As we've said before, the government's effort to battle the current economic mess is unprecedented in many ways. At the same time, today's problems, while severe, are nowhere as bad as they were in the Depression. 

And the Markets May Be Stabilizing

Stocks started today with broad-based weakness because of the economic and banking woes discussed above. But then they mounted a good rally to end the day in positive territory.

Even so, the recent market weakness has led some pundits to warn that stocks will inevitably return to new lows because of the seemingly endless bad news on the economy.

Of course, we can't rule that out. But two sets of facts will help you to realize that, come what may, we really are seeing some improvement in the stock market.

First, consider that the Dow Jones industrial average dipped below 8,000 today for the first time since its low point in November. Yet the number stocks hitting new 52-week lows today on the New York Stock Exchange totaled just 90. This number is a modest percentage of the number of new lows back in November, which in turn was much smaller than the number of stocks at new lows when the average previously bottomed in October. In other words, even as the major averages have touched lows, the broad market has done much better.

Second, markets usually take time to establish a major bottom after a long, sharp decline. A classic double bottom is not unusual. This is what happened as stocks recovered from the 2000-2002 bear market. On Oct. 9, 2002, the Standard & Poor's 500 closed at 776. It wasn't until March 11, 2003 that the bottoming process ended with the S&P 500 dropping to 800. Following this successful test, stocks embarked on a 55-month bull market before peaking in October 2007.

Stay cautious, patient—and optimistic.

Terrible news on both the economy and banking system sent stocks tumbling this week.

Among the economic reports, U.S. retail sales declined for the sixth month in a row. Oil demand is weak, and inventories continue to mount. Last week's unemployment numbers for December were grim. So are the economic headlines from Europe and Japan.

Of greater concern for future growth prospects is the bad news coming out of the banking sector. Most of the headlines involve Citigroup and Bank of America, but other bank stocks in the U.S. and Europe are down sharply too.

Citigroup is expected to soon announce big losses, and it clearly needs more capital, even after receiving $45 billion in government help last November. At today's low, its shares were down 91 percent from their high and 43 percent over the last five days alone. There is speculation that the U.S. will have to take over Citigroup, whose Robert Rubin is finally resigning after many years of huge compensation with little to show for it—in addition to denying any responsibility for Citigroup's meltdown.

The U.S. government is close to a deal that would give billions in additional aid to Bank of America to help it close its acquisition of Merrill Lynch. Reason: Larger-than-expected losses at Merrill. BAC shares were down 85 percent from their high and 43 percent over the last five days.

Unfortunately, the massive greed, incompetence and neglect of many financial leaders will make it harder for the economy to rebound. Here's why.

Because of their huge losses, the big banks need capital, both to meet regulatory requirements and to encourage them to lend. Lacking capital, they have less ability and willingness to create credit, which is necessary to loosen the economy and foster growth.

The estimate of losses from loans in the hands of banks and other lenders is running as high as $2 trillion. Estimating loan losses precisely is impossible. And the numbers vary with what happens to the economy, prices of homes, commercial real estate and other assets, and various assumptions. But the number has been growing, and it poses a formidable obstacle to a sustained recovery.

It's generally agreed that financial institutions still have a long way to go in fully recognizing and writing off their losses. When banks or other financial institutions recognize a loss, it depletes capital. And when their share prices fall, it makes it harder for them to raise new capital. 

But the Stimulus Will Help…

Details of President-elect Barack Obama's economic-stimulus package, currently estimated at $825 billion, were released today. It's the largest economic stimulus legislation ever put forward by the federal government, in an all-out effort to deal with what is likely the deepest economic downturn since the Great Depression.

The plan calls for $275 billion in tax cuts and $550 billion in spending, including $90 billion for infrastructure projects. Whatever form the package eventually takes, the earliest it's currently expected to be signed into law is mid-February.

Once the plan is passed and whatever its pros and cons, it will follow the TroubledAsset Relief Program (TARP) and moves by the Federal Reserve in working through the economy. The positive impact of this massive economic stimulus should show up in a significant way starting in the second quarter.

Meanwhile, we have already seen some improvement in the credit market. The TED spread, the premium banks pay for loans compared to the U.S. government’s borrowing cost, is now at a 5-month low, and the LIBOR, a measure of short-term rates, is near its lowest since 2003. Mortgage rates are coming down. And the corporate and municipal bond markets are acting well.

Don't forget that the Federal Reserve has effectively cut rates to almost zero, and the monetary base has doubled in the last year, with no signs of slowing yet.

As we've said before, the government's effort to battle the current economic mess is unprecedented in many ways. At the same time, today's problems, while severe, are nowhere as bad as they were in the Depression. 

And the Markets May Be Stabilizing

Stocks started today with broad-based weakness because of the economic and banking woes discussed above. But then they mounted a good rally to end the day in positive territory.

Even so, the recent market weakness has led some pundits to warn that stocks will inevitably return to new lows because of the seemingly endless bad news on the economy.

Of course, we can't rule that out. But two sets of facts will help you to realize that, come what may, we really are seeing some improvement in the stock market.

First, consider that the Dow Jones industrial average dipped below 8,000 today for the first time since its low point in November. Yet the number stocks hitting new 52-week lows today on the New York Stock Exchange totaled just 90. This number is a modest percentage of the number of new lows back in November, which in turn was much smaller than the number of stocks at new lows when the average previously bottomed in October. In other words, even as the major averages have touched lows, the broad market has done much better.

Second, markets usually take time to establish a major bottom after a long, sharp decline. A classic double bottom is not unusual. This is what happened as stocks recovered from the 2000-2002 bear market. On Oct. 9, 2002, the Standard & Poor's 500 closed at 776. It wasn't until March 11, 2003 that the bottoming process ended with the S&P 500 dropping to 800. Following this successful test, stocks embarked on a 55-month bull market before peaking in October 2007.

Stay cautious, patient—and optimistic.

After climbing 15-20 percent from their deeply depressed November lows, the major U.S. equity indexes tumbled yesterday and were down modestly today. We see three reasons for the sell-off. First, some profit-taking was inevitable after the runup. Second is the increasing realization that corporate earnings reports for the quarter just ended and probably the current one will be grim.

Third is gloomy news on the employment front. Several well-known companies have announced layoffs recently. And expectations are that tomorrow's monthly report from the Labor Dept. will show a sharp job loss for December and an increase in the unemployment rate to 7.1 percent, which would be the highest in more than 15 years.

In a nutshell, investors are trying to determine the depth, breadth and duration of this recession. Undeniably, the U.S. economy currently is in bad shape. But it already has been in recession for 13 months. Odds are this downturn will turn out to be the longest since the Great Depression. Recessions lasting 16 months occurred in 1973-74 and 1980-81. Call this the Great Recession.

But keep in mind that the current unemployment and corporate-earnings news is historical, and we already knew that the economy weakened dramatically in the last several months of 2008. We also expect that the unemployment rate will continue to rise in the coming months while corporate earnings will stay under pressure.

In our view, though, this information is largely already priced in the stock market. In October-November, we experienced extreme price declines, investor pessimism and market volatility as the markets looked ahead and saw bad news on the horizon. But now we have many deeply undervalued stocks.

Current and future efforts to stimulate the economy are unprecedented. The program includes a monetary policy that will force interest rates down across the board, flood the financial system with money, inevitably unfreeze the credit markets and encourage people to start taking prudent risk again. This will take time, but it will happen. For example, mortgage rates are at a 50-year low. Combined with lower home prices, this dramatically increases the affordability of housing again.

All this doesn't mean we can’t retest the October-November lows, although we think that probably won't happen. The key point is that this is a great time to be gradually accumulating high-quality financial assets at very attractive prices.

What's more, the financial markets almost certainly will rebound long before the headlines tell you the economy is improving. While not infallible, this historically is a very reliable rule of thumb.

Consider this: During the Depression, the U.S. stock market actually hit its low in July 1932, four months before the election of Franklin D. Roosevelt as president and eight months before he took office in March 1933. By then, stocks had already advanced 30 percent. All told, stocks jumped 473 percent through 1937.

Yet the economy stayed depressed throughout the 1930s, although the jobs market and the broad economy slowly and erratically moved up from their worst levels. In other words, the direction of the economy was more important than its absolute level.

The bottom line: We don't need a new economic boom for financial markets to do well. We need only to see signs of economic improvement. Considering that last fall, the primary concern was survival of our financial system, it's evident that we're already making progress.

Investing in Consumer Frugality

The U.S. consumer is now embracing a new, long overdue shift toward spending less and saving more. Call it the new frugality.

In early October 2008, we asked in a weekly update, "Have you cut back on your discretionary spending in the last few weeks? We’d be surprised if you answered no." As we explained, "The main obstacle to growth now, we believe, is slumping consumer spending."

Back, then, our key point was that you should avoid stocks of companies that depend on discretionary consumer spending.

In early November, we advised, "One of the sturdiest economic clichés has long been that consumers keep on spending during economic downturns. But now evidence is mounting that shopping no longer holds the appeal it used to. Conspicuous consumption is out, frugality is in—and even virtuous. This is important because consumer spending accounts for more than two-thirds of the economy."

We reiterate that shares of companies that depend heavily on discretionary consumer spending generally should be avoided. And we still believe that with the U.S. consumer's multidecade spending spree winding down at long last, the recovery of the broad economy will take time.

Economists use the term "paradox of thrift" when consumers are saving more and spending less just when the economy needs them to spend more. What we say is: "Obviously, they're spending less because times are tough."

U.S. household debt, which grew steadily from when the Federal Reserve began to track it in 1952, declined for the first time in the third quarter of 2008. We expect the numbers to show a further drop when they're reported for October-December 2008. In recent years, as Americans spent more than they earned, the personal saving rate dipped below zero. Economists now expect the rate to rebound to anywhere from 3 percent to 10 percent in 2009-10.

In other words, Americans finally are spending less and saving more. Not good for the economy now but essential in the long run.

This sluggish economic environment is very good for the bonds of financially strong companies. In general, the non-Treasury credit markets are even cheaper than U.S. stocks.A good way to invest in these high-quality corporate bonds is through iShares iBoxx $ Investment Grade Corporate Bond (LQD). This unmanaged exchange-traded fund currently yields 5.5 percent and also offers capital-appreciation potential.

Trust is in short supply in the credit markets. That’s really not a surprise because the financial crisis started in the credit markets, and that’s likely to be where the first signs of major improvement occur.

For now, banks remain reluctant to lend money. Instead, they are hoarding even the huge sums they’ve received from the federal government. Their holdings of cash have nearly tripled to just over $1 trillion in three months, according to Federal Reserve data.

Perhaps a bigger concern is the outlook for securitization. This is the process that enables banks and other lenders to bundle loans and bonds into securities for sale to investors. Many credit-market securities have plunged in value, making it all the more difficult to sell new ones.

This so-called shadow banking system now accounts for most of credit worldwide. Credit will remain tight until financial companies can securitize debt, which depends on investors’ willingness to buy the securities.

On that score, there have been signs of some improvement, such as declining home-mortgage rates. And prices of other high-quality debt have been rising too, with declining yields. Another positive trend is that over the last two weeks, the difference between the yield on "junk" corporate bonds and Treasury bonds has shrunk by two full percentage points. Other credit spreads have also narrowed sharply since the Federal Reserve dropped its key target interest rate to nearly zero and indicated that rates would stay low for a while.

Such credit spreads are a closely watched measure of how much risk investors and lenders are willing to take. Lower spreads generally mean they're more willing to lend. Back in early 2007, credit spreads were at historic lows, reflecting excessive eagerness to lend. We know how that turned out.

But the key point is this: The credit markets are improving, with spreads starting to narrow from historic highs. It has been and and likely will continue to be a slow process, particularly with the underlying economy still weak. But over time, credit conditions will get better. And that inevitably will lead, albeit in fits and starts, to gradual improvement in the equity markets too. 

The Compelling Case for Stocks

In addition to gradually improving credit-market conditions, equity markets possess positive qualities of their own.

For one thing, the Standard & Poor's 500 carries a dividend yield of 3.2 percent, its highest since 1990. More importantly, its average yield exceeds that of 10-year Treasury issues by 1.1 percentage points. Since many companies in the index don’t even pay a dividend, this means that many others pay 4 percent, 5 percent, 6 percent and more. This is a reflection of both depressed investment values and the high level of income available from stocks at a time of historic lows in Treasury and money-market yields.

Another major plus is that there’s now an estimated $8.9 trillion sitting on the sidelines in cash and money markets. High cash levels and low stock prices historically go hand in hand. The current level as a percentage of the stock market’s capitalization matches that at the market bottom in 1990.

Keep in mind that this huge amount of liquidity generally has yet to include the massive amount of money that will be created as a result of the Federal Reserve’s recent unprecedented actions to stimulate the economy and financial system.

This pattern is similar elsewhere: a global recession, beaten-down investment values, large amounts of cash on the sidelines, and unprecedented aggressive monetary and fiscal policies.

Despite perhaps inevitable comparisons between today’s economic challenges and those of the 1930s, we see two major differences for the better now. First is the sheer size of today’s stimulus package: much bigger than the one back then. Second, is the timing of the current program: It has started in full force much earlier than efforts back then.

Unfortunately, 2008 will go down in history as one of the worst years not only for the financial markets but also for real estate. Many challenges lie ahead. But fortunately 2008 is now history.

Just as the market bottomed in the 1930s before economic stimulus programs took hold, we believe the worst is behind us in terms of the markets now.

Come what may, we’ll do our best to guide you through the ups and downs.

Happy New Year!

Yes, the economy looks bleak right now. But ongoing government efforts to support the economy and the financial system will bring increasing evidence of stability and then growth.

Meanwhile, with yields on super-safe U.S. Treasury issues and cash-equivalent vehicles at absurdly low levels, we see excellent opportunities for income and even capital-appreciation potential elsewhere.

A year ago, the benchmark 10-year U.S. Treasury note was yielding about 4 percent. Now it’s at less than 2.2 percent.

Meanwhile, mortgage-backed securities issued by government agencies such as Fannie Mae, Freddie Mac and Ginnie Mae carry AAA ratings for credit safety and pay 4-5 percent.

Investment-grade corporate bonds, rated A or better, typically pay 6-7 percent or more.

And because of the staggering, unprecedented amount of financial stimulus that the U.S. government is providing, inflation is highly likely to come back as the economy recovers. It’s too soon to say exactly when that will happen. Meanwhile, though, Treasury Inflation-Protected Securities (TIPS) are currently priced as if there will be little or inflation over the next 10 years.

That makes no sense to us. And it means a real bargain for you. 

Home Sales Plunge, But Mortgage Applications Soar

Home-sale activity and prices fell at their fastest rate in 40 years in November, amid a rapidly deteriorating economy over recent months.

Sales of previously owned homes, which make up most of the market, declined 8.6 percent in November, according to the National Association of Realtors. The median home price fell 13 percent in November from a year ago and 21 percent from its peak in July 2006.

A deepening recession and tight credit conditions are compounding the problems of oversupply and foreclosure in the housing market, As one observer correctly put it: “Housing dragged down the markets this summer. Now it’s the economy and financial markets that are dragging down housing.”

The NAR estimates that distressed sales accounted for about 45 percent of all sales in November, with the sellers facing foreclosure or having to sell their homes for less than the value of their mortgage.

Home values overall are now expected to decline through at least the first half of 2009 because of the weak economy and a continued high level of foreclosures.

But the latest home-sale numbers do not yet reflect some good news: a sharp drop in mortgage rates that should continue as the Federal Reserve buys up mortgage-backed securities and aggressively pushes down other rates. Mortgage applications have surged to historic levels. While much of that reflects refinancing, it’s still money in homeowners’ pockets. And with lower prices and lower mortgages rates, housing is now getting much more affordable. Over time, credit conditions should loosen, enabling more potential buyers to qualify.

Another plus for the housing market is that home-building activity has declined so much that the backlog of unsold units is starting to be absorbed at a fairly rapid clip even with a sluggish sales rate.

The bottom line for housing: It will take more time for the market to recover. But conditions are improving now. 

Be Thankful, Look Ahead, Stay Focused

We're nearing the close of what has been a terrible year for many. And we’re in the midst of what is probably the worst recession since World War II. How it will all play out is impossible to say with absolute certainty.

But we believe this is also a time to focus on what we do have, not on what we don’t. That includes looking for the silver lining to this mess that came to a head in 2008. On that score, we see two benefits.

First, we can use this economic downturn to help us examine our goals and priorities. Second, the problems of 2008 will bring us excellent investment opportunities in 2009. We’ll be here to guide you.

The Federal Reserve slashed its target rate for the overnight federal funds rate to between zero and 0.25 percent. The move, from 1 percent previously, was even bigger than expected. This continues the dramatic decline in Fed rates from 5.25 percent in September 2007. Another Fed lending rate, the discount rate, will go to 0.5 percent, a level last seen in the 1940s.

Of even greater practical significance, the central bank said it will “employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.” In effect, this is a blunt announcement that the Fed will print as much money as necessary to revive the frozen credit markets and fight what perhaps is shaping up as the nation’s worst economic downturn since before World War II.

Also of note, the Fed added that it expects interest rates to remain “exceptionally" low for some time.

Though historically important, the latest Fed rate cut is largely symbolic. Reason: The funds rate, which affects what banks charge for lending their reserves to each other, had already fallen to nearly zero recently. The problem is that banks are still reluctant to lend.

So the Fed, in effect, is stepping in as a substitute for banks and other lenders. To put it another way, as the financial system “deleverages”—that is, reduces its use of debt—the U.S. government is “leveraging up” as it tries to restore balance to the system and get the credit markets going again. Among the tools the Fed will use, it said it will buy large quantities of mortgage-related bonds, longer-term Treasury bonds, corporate debt and even consumer loans. This is to translate into an expanding array of new lending programs for businesses and consumers.

The Fed’s latest moves and its forceful accompanying statement reflect the reality that economic activity in the U.S. and indeed the world has dropped sharply since September. That said, the Fed’s actions and comments are not surprising because there had previously been numerous comments that the federal government would do whatever it could to fight this serious problem. As we noted in previous weekly updates to you, Ben Bernanke said six years ago that central banks could combat deflation by buying longer-term Treasury and mortgage-backed securities to drive down interest rates. He also said that the government can simply issue more money to fight deflation.

And make no mistake, deflation is a risk, although how much of one is hard to say. The Consumer Price Index fell 1.7 percent in November, the steepest monthly drop since the government began tracking prices in 1947. Plunging energy prices largely drove the decline, but even the so-called core inflation rate (excluding food and energy) was essentially zero. In addition, labor market conditions continue to deteriorate, and consumer spending, business investment and industrial production are on the decline.

Falling prices help consumers in the short run, particularly in a weak economy. But if prices continue to fall over the longer run, it will only discourage spending, effectively boost borrowing costs and threaten asset values.

Powerful Stimulus for High-Quality Bonds

Debate over the effectiveness of government actions to bolster the economy will continue for many years. But what about now? One thing we can say with a high degree of confidence is that these steps are great for investments in high-quality bonds.

You see, yields on the safest debt, U.S. Treasury securities, have already fallen to levels that are basically incomprehensible. Here are the latest numbers:

30-year T-bonds: 2.55 percent.

10-year T-notes: 2.05 percent.

Five-year notes: 1.25 percent.

Two-year notes: 0.67 percent.

Attractive? In a word, no. With those yields so low, investors have every incentive to start taking a little more risk again by moving out to Ginnie Mae and Fannie Mae mortgages, where yields approach 5 percent. But there’s really not much risk involved because the federal government is now a major buyer there. Looking ahead, investors are also starting to move more aggressively into investment-grade corporate debt, where yields average more than 7 percent.

An even more compelling reason to move out of the shelter of risk-free cash is that cash now holds less appeal than it has all year. The Federal Reserve's most recent cut is pushing rock-bottom money-fund yields even lower. The seven-day average yield on taxable money funds fell to 0.88 percent this week. Rates topped 4 percent last year.

However, so-called prime funds do pay better yields. Prime funds buy short-term debt, including commercial paper. Among the two most reliable are Vanguard Prime Money Market and Fidelity Cash Reserves, both still yielding over 2 percent.

The financial world’s fearful flight to safety reached a new high—or was it a low? —this week. Like stuffing cash under a mattress, big investors in both the U.S. and abroad were so eager to park money in United States government debt securities, apparently the world’s safest “investment,” that they agreed to accept no interest.

Investors accepted a 0 percent rate in the government’s auction Tuesday of $30 billion worth of four-week notes. So strong was the demand that the government could have sold four times as much.

In addition, investors briefly were willing to take a small loss for holding another ultra-safe security, already-issued three-month Treasury bill.

So low is the level of expectations these days that some investors believe breaking even, more or less, means coming out ahead. And so extreme is the level of fear that these investors are willing to lend money to a government that faces spiraling debt and deficits. Amazingly, foreign central banks have been big buyers of short-term Treasury issues throughout 2008. Money-market funds and hedge funds recently have been among the other big buyers.

On the plus side, rock-bottom financing costs will help the federal government finance its various and growing number of programs aimed at reviving the economy. But the rapid decline in Treasury yields unfortunately also has the potential to make efforts to stimulate the economy more difficult as financial institutions take the money that the Federal Reserve is pumping into the financial system and stuff it into Treasuries rather than investments that can help the economy.

But for you, this panicked rush to safety at all cost by the “smart money” offers tremendous opportunity, as we explain in the current issue of Leeb’s Income Performance. With valuable financial assets that actually give you the chance to make money driven down to absurdly low prices, you can use some of your own cash to snap up assets that the big guys have been forced to unload.

When Fear Is High But Assets Are Cheap

On Nov. 20, the S&P 500 closed at an 11-year low. By many measures, stocks were then at, and are still near, their most attractive levels in decades, and investing now for the long term carries unusually low risk.

At the November low, the S&P 500 was down 52 percent from its October 2007 peak, while the Dow Jones industrial average was down 47 percent. These declines are among the worst in modern history.

What’s more, valuations are very attractive. At the November low, the S&P 500 traded at 10.4 times average corporate profits over the past five years, which was among the lowest readings of the last 50-plus years. Based on a 10-year earnings average, the S&P 500 was at its lowest level in 21 years.

In addition, a variety of investor sentiment measures reached extreme levels of fear last month. Collectively, this is a contrary indicator that occurs at or near market bottoms.

To be sure, even the combination of dramatic price declines, exceptional valuations and extreme investor fear don’t automatically mean we’ve hit the absolute bottom. In our view, though, the process of establishing a major stock market low that will hold for years started in mid-October, is still going on and may continue a while longer. More importantly, it’s extremely likely that the worst is well behind us, particularly given two basic facts. First, the recession is already a year old. Second, massive government stimulus to the economy will lead sooner or later to more spending, more confidence and a return to growth.

It’s only prudent that you be conservative in your current spending and long-term planning. But it’s also a good time to invest gradually in high-quality vehicles for income and growth, on market weakness. 

Bad Economy, Better Market

The ability of financial markets to rally in the face of bad news is a classic sign of improving investment conditions. In fact, historically it has proven to be one of the most reliable signs.

As we reported last week, the National Bureau of Economic Research announced on Monday Dec. 1 that the U.S. economy officially entered a recession in December 2007. All last week and this week, we’ve seen a steady stream of grim economic news and dire headlines.

Not surprisingly, the U.S. stock market tumbled yet again on the recession announcement plus other bad news. From that Dec. 1 low, though, the Standard & Poor’s 500 climbed 10 percent before dropping today.

The ability to ignore bad news was most striking last Friday, after the release of one of the worst employment reports in decades. The 533,000 jobs lost in November marked the largest one-month drop since December 1974 (although the current losses are a much smaller share of total employment). Revisions to earlier figures showed employers shedding almost 1.3 million jobs since September.

Yet the S&P 500 jumped 3.7 that day. If news that bad doesn’t knock the stock market down, what kind of news would it take? For months, stocks had plunged at any sign of bad news. But it’s not happening as much now.

Consumer spending is down sharply. With numerous announced lay-offs already in December, it’s probable that jobs and consumer spending will stay weak for several months at least. And the current quarter could see a sharp decline for the overall economy.

But bear markets tend to end long before the bad news does. And the message of the markets is more important than headlines.

The U.S. economy officially sank into a recession last December, the National Bureau of Economic Research said this week. Now you tell us!

This means the current downturn officially already has lasted longer than the 10.5-month average for the 10 previous recessions since World War II. And odds are it will turn out to be the longest since the Great Depression. Recessions lasting 16 months occurred in 1973-74 and 1980-81.

The NBER’s declaration came despite the fact that that the U.S. economy actually expanded slightly over the first half of 2008. This is because the Bureau also uses a variety of other key indicators, including payroll employment and personal income. Both peaked in December 2007. Job losses have occurred every month this year, while personal income has declined steadily since June. And housing prices, which generally held up during the previous six recessions, have declined all year too.

Consumer spending plunged in the third quarter, with a further decline in the fourth quarter. Consumers account for about 70 percent of U.S. economic activity, and the spending pullback is occurring despite the sharp decline of gasoline prices from all-time highs.

But the good news is that the recession already has lasted a year. What’s more, the NBER is notorious for long delays in making recessions official. So late, in fact, that the announcements often come after the recession has ended!

This time, it took the NBER a year. The 2001 recession was officially recognized eight months after its start—in the same month it ended, although that wasn’t announced for another 20 months. The July 1990 peak was announced in April 1991—the month after it ended, for which the announcement arrived in December 22, 1992. The 1981-82 announcements came eight and six months respectively after the fact—relatively quick. The January 1980 peak was announced in June 1980, one month before the recession’s end, which wasn’t to be announced for another year.

So the NBER often rings the bell on the peak of the business cycle just about the time conditions are starting to improve again, with more long delays on pronouncing the recession over.

The point is, announcement of a recession is at best a look through the rearview mirror. Admittedly, it seems unlikely now that the current downturn will end within the next four months. But it always looks grim at or near the bottom. Historically, announcement of a recession is, if anything, a sign that a turnaround may be closer than most people think. 

Lower Mortgage Rates Will Boost Housing Market

The housing market, which led the way into the financial crisis, may soon start to stabilize.

The U.S. Treasury is considering a plan to help by pushing down mortgage rates for home purchases. The plan would use Fannie Mae and Freddie Mac to buy securities supporting bank loans at rates of as low as 4.5 percent for standard 30-year fixed-rate mortgages. The current rate is about 5.6 percent.

If the plan is put into action, it likely will be early in the Barack Obama administration. Treasury and the Federal Reserve are already working to bring mortgage rates down through a program announced last week in which the Fed will buy up to $600 billion of debt issued or backed by Fannie and Freddie, Ginnie Mae and the Federal Home Loan Banks.

The lower mortgage rates would be available only to qualified borrowers who are buying a home. But all mortgage rates likely would head lower, leading to another wave of refinancing. In fact, that’s already happening. Applications to refinance home mortgages jumped by the largest amount in the Mortgage Bankers Association survey’s 18-year history this week, as borrowers flocked to take advantage of falling mortgage rates.

Beware the Treasury Bubble

Investors’ continued flight to quality and a dramatic drop in the global economy since September have combined to send interest rates on U.S. Treasury securities to historic lows. Fueling the rate decline are aggressive moves by the world’s central banks to inject liquidity into the financial system and slash the cost of capital.

Central banks around the world delivered sweeping interest-rate cuts Thursday. The European Central Bank lowered its benchmark key rate by 0.75 percentage points to 2.5 percent, marking a decline of 1.75 percentage points in two months. The 15-nation eurozone economy collectively is second in size only to the U.S.

The Bank of England cut its key rate by a full percentage point to 2 percent—its lowest level since the bank’s founding in 1694. This move follows a 1.5 percentage point reduction last month. Sweden’s Riksbank slashed its key rate by 1.75 percentage points to 2 percent. The central banks of New Zealand and Indonesia also made deep rate cuts.

Here in the U.S., the buying spree in Treasury securities sent yields careening to new historic lows this week. As we write this, here were the yields on Treasury issues:

Treasurys obviously have benefited in a big way from investor fears about the financial system, the economy, deflation, etc.—plus the possibility that the Federal Reserve increasingly will buy government debt.

But ask yourself this simple, commonsense question: Would you lend your money at any of the above rates and time periods?

If government efforts to stimulate the economy prove even mildly successful, Treasury securities will reverse course, with lower prices and higher yields, as investors start to take some risk again. Other income vehicles, ranging from government-backed mortgages to high-quality corporate bonds to dividend stocks of financially strong companies, will benefit—while Treasurys lose value. And they all pay much better yields now.

Stock and bond markets continued their post-election swoon this week, falling to new lows. 

Among the issues weighing on the markets are worries about rising defaults by borrowers because of the slowing economy and declining property values. Prices of corporate and real-estate bonds fell to their lowest levels in more than 20 years. This in turn particularly slammed shares of financial institutions that hold these bonds: banks, insurance companies and brokers.

A second, ongoing theme is the continued flight from risk, particularly by large, overleveraged investors that need to raise cash.

Adding to the financial markets’ woes is grim economic news, with projections of more to come. Minutes from the Federal Reserve's latest meeting in October showed that its members expect the recession to last at least through the middle of next year, and possibly all of 2009.

Financial markets in the rest of the world are weak too, even more so in many cases. Japan, the European Union and Hong Kong, among others have entered recession. Great Britain has or will soon do so.

But the Federal Reserve also signaled that it will slash interest rates even lower if necessary if the economic picture continues to worsen. Europe is preparing another significant stimulus package. And even the European Central Bank, which remains behind the curve, will have to act soon.

The ECB, which just two months ago was primarily concerned about rising inflation and greatly underestimated how much Europe’s economy would slow, has cut its benchmark rate by just one percentage point since raising it in July. Meanwhile, the Fed has slashed its rate by 3.25 percentage points and the the Bank of England has done so by 3.75 percentage points. The ECB's rate currently is at 3.25 percent compared with 3 percent at the Bank of England and 1 percent at the Fed.

Both the ECB and the BOE will be cutting some more. These steps, combined with additional government stimulus packages will continue the aggressive fight against the global credit crunch and downturn. 

Is Deflation a Real Risk?

U.S. consumer prices in October registered their largest single-month decline since before World War II. Does the price drop of 1 percent for a broad range of goods and services signal a prolonged period of deflation—falling prices throughout the economy?

Almost all of the consumer price drop occurred in energy and food costs. But even the core index fell slightly—by 0.1 percent. This is unusual, and it confirms our often-stated view here that the American consumer is undergoing a long overdue change from excessive consumption to frugality. Consumer borrowing is down 1.5 percent from a year ago, the first decline since 1990.

A weak economy, more job losses and continued debt reduction could combine to dampen inflation well into 2009. But it would take a dramatic economic contraction to cause long-term deflation. And the U.S. government and the Federal Reserve are far from out of bullets here.

In a 2002 speech, before he was the chairman of the Fed, Ben Bernanke said central banks could combat deflation by buying longer-term Treasury and mortgage-backed securities to drive down interest rates. He also noted that the government can simply issue more money. He referred to a statement made by Milton Friedman about using a “helicopter drop” of money to fight deflation. Hence Bernanke's nickname, "Helicopter Ben.”

The lesson of the Great Depression and of Japan in the 1990s and earlier this decade, is that it is necessary to be very aggressive about combating the threat of deflation. There is ample evidence that the Fed will flood the financial system with liquidity, if necessary, whether through buying assets or even printing money. And Congress is expected to enact a significant fiscal stimulus package in January after the new administration and Congress take office. New tax breaks and government spending on infrastructure and other projects are also possible.

If you put money into peoples’ pockets, they will spend it. 

Keep Your Head, Stay Conservative

Capital preservation and risk control are essential when market conditions turn unfavorable. Protecting yourself is always more important than trying to time the bottom, regardless of how cheap investments may seem.

But now the financial markets seem to be consumed by emotion. And emotion, be it greed or fear, always eventually drives the markets to extremes. Today, fear is paramount.

If—and only if—you’re a long-term investor, this is a great time to be putting some of your cash to work. By the time the good news comes, prices will be significantly higher than they are today.

We stress the importance of investing only in high-quality vehicles. We prefer shares of financially strong companies that pay good, growing dividends. You should be able to keep that money invested for five years, if necessary. And first you should have at least a year’s worth of living expenses in savings.

This week’s biggest news is the announcement that the Federal Reserve and U.S. Treasury will pump yet another $800 billion into troubled credit markets.

What makes this different and better than previous such announcements is that the money is more likely to directly benefit consumers and investors, not just troubled banks with incompetent management.

Accounting for the bulk of the latest stimulus package, the Fed plans to purchase up to $600 billion of debt issued or backed by Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Banks. The announcement pushed down rates on 30-year mortgages by as much as one-half percentage point, to about 5.5 percent.

Lower rates could help borrowers looking to buy or refinance homes, potentially propping up sagging housing markets. The more immediate impact will come from homeowners refinancing their mortgages, which will put more cash in their pockets, helping to stimulate the economy.

About $6 trillion of home mortgages were originated in 2005-07, and interest rates on most of the fixed-rate loans exceeded 6 percent. Mortgage rates could move down to 5 percent or less before long.

As we advised in last week’s update, “In a 2002 speech, before he was the chairman of the Fed, Ben Bernanke said central banks could combat deflation by buying longer-term Treasury and mortgage-backed securities to drive down interest rates.”

By themselves, these moves of course won’t end the financial crisis or the recession. For example, only borrowers who have the cash and credit rating to qualify for mortgages under current lending standards will benefit. So too, lower rates won't help owners who are unable to refinance because they owe more than their homes are worth.

But the process, we hope, will aid responsible consumers who, through no fault of their own, have been hurt by the greed, stupidity and incompetence that brought our financial system to where it is today. 

Markets Upbeat Despite Weak Economy

After their first three-day rally since August, stocks advanced again today despite more reports of a declining economy. All told, since dropping to an 11-year low last week, the Standard & Poor’s 500 has rebounded some 18 percent.

The rally came in the face of more news about declining consumer spending. Stocks were overdue for a bounce. But the point is, they typically rally even when the economy is weak. Increasing evidence that the federal government will do whatever is necessary to stave off deflation and depression have helped fuel the advance, which started with news of Tim Geithner’s nomination as the next Treasury Secretary and continued with the rescue of Citigroup.

Looking ahead, President-elect Barack Obama, with his economic team in place, is pushing for an additional stimulus package estimated to be about $600 billion. The plan is centered around stimulating spending on infrastructure projects and alternative energy.

Meanwhile, yields on 10-year U.S. Treasury securities have now tumbled to 3 percent, their lowest level in at least 31 years. Over time, low Treasury yields, combined with massive government liquidity injections, will boost the appeal of government-guaranteed mortgage securities, high-quality corporate debt and dividend-paying stocks of financially strong companies.

Cheap Monkeys, Cheap Stocks

We recently came upon a fable that’s been making the Internet rounds. Maybe you’ve seen it. The story’s stated purpose is to relate how Wall St. works. But to us, the message is that it’s time to buy monkeys again.

Once upon a time in a village, a man appeared and announced to the villagers that he would buy monkeys for $10 each.

The villagers, seeing that there were many monkeys around, went out to the forest, and started catching them.

The man bought thousands at $10 and as supply started to diminish, the villagers stopped their effort. Then he said he would now buy at $20. This renewed the efforts of the villagers and they started catching monkeys again.  Soon the supply diminished even further and people started going back to their farms.

The offer increased to $25 each and the supply of monkeys became so scarce that it was an effort to even see a monkey, let alone catch it.

The man now announced that he would buy monkeys at $50!  However, since he had to go to the city on business, his assistant would now buy on his behalf.

The assistant told the villagers, “Look at all these monkeys in the big cage that the man has collected. I will sell them to you at $35 and when the man returns from the city, you can sell them to him for $50 each.” The villagers rounded up all their savings and bought all the monkeys.

Then they never saw the man or his assistant ever again,
only monkeys everywhere!
 

Plenty of monkeys—and stocks—cheap. 

Count Our Thanksgiving Blessings

If there was ever a year we’d like to forget from a financial standpoint, it’s this one. But we’ve made progress from the depths of the financial crisis in September, when it seemed that putting cash under a mattress seemed like the best plan.

What’s more, investment assets are on sale. If you’ve kept significant amounts of cash on the sidelines, as we’ve advised, you now have the opportunity to snap up high-quality investments at low prices for good income and appreciation potential. For specifics, check out the December issue of Leeb’s Income Performance, which you’ll soon receive.

After last Tuesday’s Election Day advance, the Standard & Poor’s 500 tumbled roughly 16 percent, back down to its October lows, before rebounding sharply today. We see three basic reasons for the big decline.

First was renewed asset liquidation because of the need to deleverage among hedge funds and other stress financial institutions. Hedge funds have been raising cash in anticipation of an imminent deadline for investors in many funds to submit requests to withdraw assets.

Second is a steady stream of news indicating a deepening economic downturn, including job losses, weak consumer spending and downard pressure on corporate profits. Exacerbating worries about how long and deep the economic slowdown will be are concerns about what’s going on in Washington, DC. More on that in a minute.

As we advised last week, economic challenges will continue regardless of who’s president, the period of wide market swings isn’t over yet and the dramatic stock advance through Election Day simply wasn’t sustainable.

Despite the new bout of selling, though, it looks like the stock market is still in that bottoming process we keep talking about every week.

Even though the major market averages traded back down at their October lows today, the number of stocks actually hitting new 52-week lows on the New York Stock Exchange (NYSE) has been considerably smaller than it was at the two previous absolute bottoms of October. To put it another way, the broad market has actually improved somewhat even though the declines of some big individual stocks have continued.

Today’s market activity provided another sign of progress. The ability of stocks to advance despite bad news is one of the best signs of strength. In the face of thick doom and gloom, the Dow Jones industrials today mounted an impressive turnaround from more than 300 points down to 550 up—an 850-point swing.

It’s never a good idea to read too much into one day’s action. For one thing, the market was deeply oversold. And in a volatile market like this, we must be cautious. So we continue to advise you to keep high cash reserves.

Yet many investment values are downright compelling, so we’re open to new opportunities. With a record $3.5 trillion sitting in money market funds in the U.S. alone and the unprecedented level of liquidity being pumped into the world economy, we see reasons for increasing optimism.

Under these circumstances, the best course of action is to invest slowly, gradually and selectively. As before, that means investing only in top-quality assets, on market weakness.

China’s Stimulus Program

This week started off on a positive note with China’s announcement of a huge economic stimulus package of about $586 billion consisting of tax cuts and increased spending on housing, infrastructure and a variety of other areas. Aimed at bolstering the domestic economy, this program should also help support the global economy.

To put the size of this stimulus package in context, it’s the equivalent to more than three times the $700 billion U.S. package passed by Congress last month, given the size of the Chinese economy. In addition, China has loosened its usually tight monetary policy by cutting interest rates three times since September.

China says yearly economic growth of at least 8 percent is necessary to provide the ongoing improvement in jobs and incomes necessary for continued popular support of its government. China’s annual growth rate is currently at about 9 percent. The massive size of the Chinese stimulus package should help not only China’s economy but also those of its trading partners, primarily in Asia.

China’s announcement is a strong reminder that most of the world’s leading nations are moving aggressively to deal with the global financial crunch and faltering economy. It’s also more evidence that inflation, a major concern just four months ago, is now way down on the list of priorities.

But there’s a potential negative for the U.S. Investors here at home have been buying Treasury securities heavily of late. But with our deficits soaring, we may become even more dependent on foreign investors to buy newly issued Treasury securities than we are now. China, one of the biggest of those investors, is now focusing more on its own economy. Other cash-rich nations may follow suit, perhaps at the expense of foreign investments.

This confirms our long-held view that U.S. government securities simply are not attractive at their current rock-bottom yields, with the risk of future price declines. 

Paulson’s Problem: Uncertainty

On Wednesday, Treasury Secretary Henry Paulson said that government assets in the $700 billion financial bailout package that Congress reluctantly approved last month won’t be used to buy troubled assets from banks.

Instead, the government may use bailout funds to inject capital into financial institutions. In addition, Paulson now wants to focus on struggling consumers by increasing the the availability of student loans, auto loans and credit cards. (We thought there were already more than enough credit cards. Aren’t they part of the problem?) He said he's also examining ways to help prevent home foreclosures.

Paulson said he’s changing plans because of intensifying pressure on consumers, and that buying troubled assets is no longer the best way to loosen up the credit markets.

We don’t claim to know the best ways for the federal government to deal with the financial crisis. But we do know that changing plans delays their implemenation. And the continued reluctance of banks to make loans with funds they receive from the government makes no sense. Wouldn’t you agree? Worse, from our standpoint as investors, this indecision undermines confidence at a time when we need much more of it.

The people have spoken. We wish President-elect Barack Obama well. We need him to succeed, and to become a president for all Americans, not just those who elected him.

After his historical election, the best thing President-elect Obama has going for him is that he isn’t George W. Bush. This fact alone should inject some confidence into the national mood. On that score, he deserves a honeymoon period from the American people.

But Obama also inherits problems of historic proportions, as you know. Few presidents have entered office facing such economic challenges. With the credit crunch now apparently lessening, the primary task at hand is to contain the current economic downturn, which shows many signs of worsening.

In addressing economic and other issues, Obama needs to decide whether his victory primarily represents a rejection of President Bush and the Republicans or an embrace of Democratic Party principles. We think it’s the former. Americans traditionally have favored competence over ideology, and mainstream solutions over strident rhetoric.

Obama's victory speech touched themes of unity and reconciliation. Among his bigger challenges will be how to deal with Congress, with its long pattern of collective incompetence, partisanship, posturing and self-interest among members of both parties.

Some of the changes that may occur could exacerbate a currently worsening business climate. These might include higher taxes, increased government regulation and more labor-friendly policies. However, the initial evidence is that such issues will take a back seat to mainstream economic issues on the Obama list of priorities. And the benefit of a revived economy would outweigh such negatives. 

Consumer Mindset: Need or Want?

One of the sturdiest economic clichés has long been that consumers keep on spending during economic downturns. But now evidence is mounting that shopping no longer holds the appeal it used to. This is important because consumer spending accounts for more than two-thirds of the economy.

The third quarter was the worst for consumer spending in 28 years, and the current quarter may be worse. Retail sales were down across the board in October, particularly among automakers and even including discounters. “Consumers are clearly putting their wallets under lock and key and reacting to the severe economic conditions at play right now," as one industry observer put it.

To be sure, most of the weakness in consumer spending can be attributed to the simple fact that people have less to spend. But what makes this time different from previous weak periods is that the twin currents of an economic downturn and asset-value deflation increasingly are causing even the affluent to conclude that shopping for recreation and therapy doesn’t hold the appeal it once did.

Now, in a major shift of consumer psychology, the talk is turning from what’s new and cool to how we’re cutting back. To put it another way, conspicuous consumption is out, frugality is in—and even virtuous. Many upper- and middle-income Americans are developing an aversion to extravagance that’s increasingly dampening high-end spending on everything from cars and travel to electronics, fashion and household goods, as well as real estate.

But there just might be a good side to this. Perhaps we won’t hear people say as frequently, “I need it” when they really mean “I want it.” 

New Chance to Buy on Weakness

On Monday, Oct. 27, the Standard & Poor’s 500 closed at a 5-1/2-year low. Then it soared a stunning 18.3 percent over the next six trading days through Election Day, Nov. 4. Some might call it an Obama rally. But the better explanation is that was more likely a long overdue rebound after a very sharp decline.

Either way, though, an advance of that magnitude was simply unsustainable. After all, an 18 percent gain in six trading ways is much more than the stock market typically provides in a whole year. The subsequent sharp decline of yesterday and today, which took the S&P 500 back down 10 percent, likely was less a vote on an Obama presidency and more an inevitable retreat after those out-sized advances. It was also a reminder both that economic challenges will continue regardless of who’s president and that the period of wide market swings isn’t over yet.

Tomorrow, the government will release its latest jobs report, for the month of October. The report will almost certainly be bad news. It may also trigger a further market decline, depending on how the latest job-loss tally matches up with expectations.

But a silver lining is that a pullback like this provides you with another opportunity to put our core guidance for you to work: Buy high quality on price weakness. By this we mean shares of companies with strong balance sheets and good cash flow, as well as high-quality bonds, as we explain in the November issue of Leeb’s Income Performance.

As you know, we have advised you for some time now to keep high cash reserves. We still do. But use some of that cash now, gradually and carefully, to invest for the long term.

In what should come as a surprise to nobody, the U.S. economy declined in the third quarter, according to a government report released today. Gross domestic product (GDP) fell at an annual 0.3 percent rate.

The main factor in the drop was that consumer spending, which accounts for about 70 percent of the economy, dipped for the first time in 17 years. Given the bad news on the economy in October, it seems likely that the pace of the downturn will accelerate in the current quarter. And the consensus view is that the economy will stay weak at least through the first half of 2009, with some fearing a deep recession.

On Tuesday, the Conference Board reported that consumer confidence fell to the lowest level ever in its survey’s 41 years. Another report showed that home prices in 20 major markets were down 16.6 percent for the 12 months through August.

Despite this bad news, the stock market has fared pretty well so far this week. Why? Because those reports simply confirm what had been clear for months: American consumers are getting squeezed, and they don’t feel so good about it.

When the stock market goes up despite discouraging economic news, it provides evidence that investment conditions are on the mend again. More on that below. 

The Fed Cuts Again

The Federal Reserve lowered its benchmark interest rate by half a percentage point to 1 percent Wednesday to percent, its second big rate cut this month and back down to the near-record lows reached in 2003 and 2004. The Fed left open the possibility of dropping rates even lower in the future, warning “downside risks to growth remain.”

The latest Fed action is part of a massive, perhaps unprecedented move by the federal government to contain the financial crisis and the economic weakness that is its inevitable consequence. Central banks around the world have joined in to varying degrees. The Fed’s latest rate cut was accompanied by reductions in China, Norway and Taiwan. Japan, the European Central Bank and the Bank of England are

expected to follow suit within a week.

We continue to applaud the aggressive response of the Fed and the U.S. Treasury. It is, of course, all too easy to second-guess each specific action, and the chronic second-guessers have been out in full force (as they usually are). It’s safe to say that when we look back on this mess, there will be widespread agreement that some things should have been done differently. Example: The Fed has lent almost $600 billion to financial institutions in the last month alone, yet banks are still reluctant to lend to businesses or consumers. But our focus here is not to offer could, would, should commentary. Our mission is to provide you with the best guidance we can on protecting and strengthening your financial security under rapidly changing investment and economic conditions.

From an investor’s standpoint of short-term self-interest, the lower interest rates are, theoretically the better it is. But cutting the Fed’s benchmark rate from 1.5 percent to 1 percent doesn’t do much by itself for the credit markets and the economy. This is because the economy’s current problems have less to do with interest rates than with a reluctance to lend money. For example, the Fed has slashed it key interest rate from 5.25 percent since the credit crisis began in July 2007. But interest rates for 30-year fixed-rate mortgages now sit at about 6.5 percent, roughly where they were back then.

The bottom line here is it will take time for this huge monetary stimulus to take effect on the economy. Credit conditions have shown some improvement, but lenders generally remain extremely risk averse. But we think it will take less time for the investment markets, which tend to look ahead and anticipate the future, to feel the positive impact. 

Market Rallies on Bad News

The big question investors need to confront these days is whether the sharp decline in stock prices has already in large part discounted the coming economic pain, including heavy pressure on corporate profits.

On balance, we believe the answer is yes. The exceptionally fast stock-price drop, fueled by forced sales of hedge funds and other big investors plus heavy mutual-fund redemptions, has created unusual values in many top-quality companies that will ride out tough economic times.

For several weeks now, we’ve talked about the bottoming process. Last week, we said, “Markets tend to rebound well ahead of the economy and much further ahead of when people start to feel better about the economy, their financial security and their investments.”

This week’s market action has provided striking confirmation of that historical tendency. On Monday, stocks dropped to a new 5-1/2-year closing low. On Tuesday, the grim consumer confidence reading mentioned above was reported. Yet, at about 2 p.m. on Tuesday, stocks exploded in one of their biggest rallies ever, with the Dow Jones industrial average closing up 889 points, or 10.9 percent. Today, the Dow climbed another 189 points despite the government report on the economy’s weak performance in the third quarter.

So this week, as in previous weeks of late, we continue to turn more positive. But we also stress that the improvement in market conditions is more likely to be gradual than rapid, and that wide price swings will continue.

We advise that you continue to draw down your cash reserves to buy the best-quality investments you can when market volatility gives you the opportunity to do so on price weakness.

Despite loosening credit and cheaper oil, investors continue to look on the dark side. The negative focus is shifting from the credit crisis to the economy itself.

Worries that slowing growth will whack corporate earnings sent the Standard & Poor’s 500 down 6.1 percent yesterday alone. Wild price swings continued today, with the Dow Jones industrials trading in a 500-point range.

Growth anxiety has increased even though the costs at which banks lend to one another and of what businesses pay for commercial paper have fallen significantly. This is partly in response to the Federal Reserve’s latest move to support the short-term debt market. Even so, investors are still seeking the safety of U.S. government securities, despite poor yields. Ten-year Treasury issues now yield an anemic 3.6 percent.

The extremely heavy selling that we’ve seen because of a combination of panic and forced asset liquidation by overextended investors has basically caused a reversal in the long-term investment trends that developed during the years of cheap financing, heavy borrowing, strong growth and low market volatility.

Unfortunately, this “cleansing of the system” is essential to the future investment profits that will inevitably spring from the crisis.

We hate to say it yet again, but the bottoming process is still going on, as the market continues to test the lows it made two weeks ago. Markets tend to bottom when economic conditions are at or near their worst—and it's hard to see that they’ll get much worse. And markets also tend to rebound well ahead of the economy and much further ahead of when people start to feel better about the economy, their financial security and their investments.

So we continue to turn gradually more optimistic. As before, we advise you to use a little more cash to buy the best-quality investments you can on market weakness. 

Dollar Rally Speeds Up

In a weekly update two months ago, we first alerted you to the U.S. dollar’s rebound from near its all-time lows in July. We subsequently advised that you cut back on some of your non-U.S. investments and bring more of your dollars home. This was because of both slower economic growth abroad and because strength in the dollar pushes down returns to U.S. investors from international markets.

.

The greenback’s rebound has now turned into a powerful advance, with a new twist: a dramatic surge vs. emerging-markets currencies. At first, the dollar advance was most evident against the British pound and the euro. Then some emerging-markets currencies joined in soon after. But it has been in October that the eye-popping gains have occurred across a broad front. This is worth noting particularly because the currency market is the world's largest.

This month alone, the dollar has surged more than 20 percent relative to the currencies of such emerging-markets nations as Brazil, Chile, Hungary , Mexico, Poland, South Africa and Turkey. These have joined now-declining currencies of more-established economies like Australia and Canada, with the British pound and euro still weakening too. All told, the dollar has now climbed about 23 percent vs. the pound to a five-year peak; and 20 percent against the euro, now at a two-year high. (The Japanese yen is just about the only major currency that hasn’t weakened relative to the dollar.)

There are two basic reasons for this dramatic reversal. The first is a flight to quality and/or a flight from risk amid global economic turmoil. Despite what all too many Americans may feel right now, our problems aren’t as bad as in many other places. Emerging economies in particular benefited from strong global growth and investment risk-taking. Now the credit crunch and slowing growth are causing investors to withdraw assets from emerging markets.

Another basic explanation is the continued reversal in long-term investment trends coupled with asset liquidation in general, noted above. The dollar and yen, formerly weak, are now stronger again. The euro, pound and others, once strong, are now down. For everything, there is a season.

More Backing for Money Funds

This week, the Federal Reserve said it will lend up to $540 billion to money-market mutual funds if necessary. This is the third major step the Fed has taken in the past month to contain the credit-crunch troubles that had spread to some money-market funds in September.

More recently, though, withdrawals from so-called “prime” money funds that buy commercial short-term paper have largely dissipated, and some investors have been heading back. For the week ended Oct. 14, prime money funds took in $16 billion, vs. outflows of $23 billion a week earlier.

Under the program, the money-market-fund industry will create new investment vehicles that can buy certificates of deposit, bank notes and commercial paper held by money funds. The Fed will lend to these so-called special-purpose vehicles, with the assets they hold as its collateral. In effect, the move ensures that money funds can raise cash quickly if necessary. This move folows others in which the Fed will begin buying commercial paper directly and provide guarantees on asset-backed commercial paper.

This step provides another injection of stability into the financial markets in the federal government’s ongoing commitment to do whatever it can to fix the financial crisis.

Monday's dramatic stock-market decline in the wake of the House of Representative’s shocking “action” has every characteristic of a major market bottom. As avid students of stock-market history, we find some comfort in the numbers amid the panic.

Among the many historical extremes, declining issues outnumbered rising ones by a 25-to-1 ratio; the trading volume of declining issues swamped advancing volume by 45 to 1; 749 common stocks hit new 52-week lows on the New York Stock Exchange, with just four new highs; and market volatility reached its highest level since October 2002. These levels of overwhelmingly negative investor sentiment historically have market the end of major market declines.

However, we don’t believe in investing just by the numbers. We ask ourselves: What, if anything, is different this time? Our answer is that there are three big factors. One is the credit crisis. The second is massive deleveraging by overextended big investors, which we have mentioned often of late. Today’s “get me out at any price” free fall in commodity-related stocks is clear evidence of the latter. Third is a global economic slowdown. Today’s collapse of the formerly strong Dow Jones Transportation Index may be an indicator of that.

So on the plus side we have extreme negativity, which should point to a turnaround. We also have the massive amount of liquidity being injected into the financial system, even aside from the awaited bailout. These are two powerful plusses.

The bottom line is similar to what we’ve advised in previous weekly updates: Stay conservative. Continue to look for buying opportunities in high-quality investments. But buy on market weakness only. 

The Bailout: It’s Not Just for Wall Street

Monday’s rejection by the House of Representatives of the $700 billion financial bailout was a shocker. The U.S. equity market alone lost $1.4 trillion in value that day.

The good news is that the Senate approved a revised bailout plan by a wide margin on Wednesday. In stark contrast to the process leading up to the House’s rejection, a bipartisan coalition of Senators, including both presidential candidates, rose to the occasion.

The bad news is that passage by the House tomorrow (Friday), while now considered likely, is far from certain. After all, the nation had been led to believe that the bill would pass last Monday.

The main obstacle to passage last Monday and to a possible repeat tomorrow is a lack of understanding of the potential consequences of no bailout.

The feelings of many Americans and of many representiatives in Congress (who are up for re-election next month) include the following:

“We’re mad as hell and we’re not going to take it anymore!”

“We don’t want to bail out the rich while everyody else gets nothing.”

“Why should taxapyers bail out the financial system?”

“This is only a short-term solution to a long-term problem..”

“Let the market decide.”

The anger is understandable. The trouble is, the credit markets are largely paralyzed. And without credit, the economy will slow dramatically. Large companies need access to capital in order to grow and create jobs. Small companies need it to operate. Families need it to buy homes. A slowing economy means reduced spending across the board by consumers and businesses. The stock market is just the proverbial tip of the iceberg. The credit markets are much bigger.

Like it or not, we are all affected. Taking major steps to rescue the economy—and ourselves—must be the top priority now. The bailout isn’t the first step and it won’t be the last. 

Europe Is Way Behind the Curve

Our concerns about the Congressional response to the credit crisis contrasts with even greater amazement about what’s going on in Europe.

Even though the credit mess started here in the U.S., it now appears that Continental Europe is heading for greater economic weakness than what we face. Reason: Europe lacks the necessary flexibility to react to the worsening economic situation.

Today, the European Central Bank left its benchmark interest rate unchanged at 4.25 percent as inflation fears among the decision makers continue to outweigh the perceived risks in the growing financial crisis.

The ECB’s decision to leave interest rates unchanged had been expected. However, Jean-Claude Trichet, president of the European Central Bank, sounded a warning over growth in the eurozone and revealed that the central bank considered cutting interest rates. The ECB is now considered likely to start cutting rates by the end of the year.

The ECB’s leisurely pace impresses us, but not in a positive way. True, the ECB’s primary mandate is price stability, while at the Federal Reserve it’s economic stability.

Instead of cutting rates, the ECB has confined its treatment of the financial crisis to increasing its short-term lending to banks, fulfilling its role as lender of last resort.

The European response toward bailing out troubled financial institutions also contrasts sharply with that of the U.S. Here, they’re considered too big to fail. There, they’re considered to big to save. One reason: There is no United State States of Europe. The European Union increasingly is at odds with itself.

For instance, Germany, Western Europe’s biggest economy, has dismissed France's call for a Europe-wide response to the financial crisis while new broad-based bank guarantees from Ireland drew criticism from other European officials.

Given Europe’s economic weakness and its high fixed costs of doing business and providing societal safeguards, the dollar should continue to rebound against the euro, at least in the near term. Overall, we would tread very carefully among Eurocentirc investments.

September 2008 likely will go down in history as the most momentous month in the history of the U.S. financial system. Last week, we hope, represented the low point in a decline that first became frequent headline news in the summer of 2007.

What brought this mess about? In brief, a lot of bad behavior—on Wall Street, in Washington DC and on Main Street too.

Congress now appears likely to approve a $700 billion to bail out U.S. financial markets, financial institutions and/or the economy, depending on your point view, primarily by purchasing bad mortgage investments. We’re encouraged by this uncharacteristically swift, bipartisan activity.

Will it be a good plan? Naturally, we have reservations that it all will work out OK. But the essence is not in the details but in massive, swift action. Why is it necessary to now instead of waiting? Because we were on the precipice of financial disaster last week. Amid frozen credit markets and mounting pressure on the economy, we can’t afford to wait additional weeks or even months, as some advocate.

For additional insight, we turn now to Warren Buffett, who made news this week with a $5 billion investment in Goldman Sachs. The legendary investor’s move is rightly seen as a vote of confidence in the troubled financial system. But it’s also a shrewd investment because the terms of the deal are uniquely favorable to Buffett, thanks to his wealth, ability to act quickly and negotiation skills.

But we were more interested in what the Oracle of Omaha had to say about the federal government’s bailout. Maybe that’s because his views are the same as ours. Buffett urged Congress to act quickly to avert an "economic Pearl Harbor." And he explained: “You have all the major institutions in the world trying to deleverage.  And we want them to deleverage, but they're trying to deleverage at the same time.  Well, if huge institutions are trying to deleverage, you need someone in the world that's willing to leverage up. And there's no one that can leverage up except the United States government.”

Buffett is also among those who believe the government will actually make money for the taxpayers. You see, it appears that the Feds in effect are buying a huge amount of financial assets at big discounts to their eventual value. And, unlike Wall Street, hedge funds and other private-sector investors, the government can manipulate the economy to get it going again, helping to make its distressed mortgage holdings more valuable.

Wishful thinking? Maybe, maybe not. But it would be sweet. In any event, it’s time for America to start turning more bullish on America.

It Looks More and More Like the Bottom

Last week, we advised you that we were increasingly confident that a market bottom was falling into place. This was primarily based on extreme levels of investor fear and panic.

Now we need to see growing evidence of improving investment conditions. Lately we’ve seen impressive strength in two good indicators with historically reliable records of anticipating moves in the broad equity market.

The first is the Dow Jones Transportation Index. Amazingly, it’s actually in positive territory for 2008. Another good sign is that small-company stocks are holding their own, with only modest declines in 2008, in sharp contrast to their large-capitalization brethren. What’s more, both the transports and the small caps tend to be more sensitive to the economy that are most other sectors of the equity market.

We remain cautious, but a little less so now. This increasingly is the time to be looking for buying opportunities in high-quality investments on market weakness.

Housing Market Needs Time and Price

The housing market remains weak, but a gradual recovery is continuing. Sales of previously owned homes declined 2.2 percent in August from July. And the median home price was $203,100, down 9.5 percent from the year before.

But the good news is that the backlog of unsold homes shrank by 7 percent from July’s record high. At the current sales pace, that works out to 10.4-month supply. Inevitably, that level is much higher than the supply of five months or less from 2000 through 2005. But that was then. A lot has changed. This is now.

A large wave of foreclosures was a significant cause for the sharp rebound in inventories. In turn, foreclosured and other deeply discounted properties are accounting for a disproportionately high level of sales now and helping to drive down the median sales price.

What’s next? With credit remaining tight and foreclosures still rising, it’s too soon to say that we’ve seen the bottom in home prices nationwide. Inventory levels may be a more important indicator than median prices.

But local conditions will vary widely, as is always the case with real esatate. And the key point, is that some improvement is occurring.

Well, where to start? As crazy as last week was, this week has been even wilder. Here’s what you need to know now about your money.

Hope that the credit crisis was moving toward resolution faded with a bang. Instead, the financial crisis accelerated. The turmoil is the worst since the Depression-era 1930s, particularly given the sheer size and impact of the global financial system.

Global equity markets collapsed this week as investor fears intensified. In the first three days alone, the Standard & Poor’s 500 tumbled 7.5 percent. before today’s strong rebound.

What’s still widely misunderstood is that much of the selling has had nothing to do with fundamental value. Rather, it has occurred because of forced liquidation of assets by dramatically overleveraged financial institutions. What they did is indefensible. And it’s undeniable that U.S. consumers also took on way too much debt during the 2002-06 credit boom. In any event, the deleveraging process has led to rising volatility and a lack of liquidity, which in turn has put further pressure on asset values.

Even so, we can say that every necessary ingredient for a market bottom has now fallen into place. First, if there was ever a time when blood has been in the streets, as the cliché goes, this is it. We saw panic selling yesterday as the so-called fear index, a measure of market volatility, shot up to its highest level since 2002. Yesterday’s trading volume was the second heaviest ever, almost reaching the record set just on Tuesday.

Second, we have now had five significant waves of pessimism over the last 15 months or so, and they seem to be peaking now. What better evidence of extreme fear is available than the fact that at one point yesterday, investors were willing to accept a negative return on one-month Treasury bills in order to ensure that they got their money back?

Third, we have had massive government intervention. Members of Congress and other pundits decry a “bailout of the rich” or the supposed sanctity of “free markets.” Yet the reality is that governments must do whatever they can in order to save the financial system. Throwing huge amounts of money at the crisis now is better than having to pay much more later. While this may well cause higher inflation later, deflation is the bigger risk now.

Last week, we advised you to be careful and conservative while dipping lightly into our high-quality recommendations on market weakness. Buy some more this week. Read on for what to buy.

A Gradual Return to the Fundamentals

Despite yesterday’s 449-point sell-off in the Dow Jones industrial average, we finally started to see a bit of logic—and value—return to the markets. Today, we saw more as the markets reversed course in a big way with the Dow jumping 410 points.

First, gold rebounded yesterday from a hard-to-fathom 25 percent decline over three months with a $70 jump, its biggest dollar move ever, in a 9 percent jump, its biggest percentage gain in nine years, to $846 an ounce. Gold was up another $5 today.

As you know, gold is a longtime favorite investment of ours because it’s the ultimate store of value and it thrives in times of turmoil. Put it this way: Gold looks great in a week when paper assets lose so much luster that major financial institutions are going out of business, Goldman Sachs shares have been down as much as 45 percent and the Russian stock market has been closed for two days to prevent further collapse.

Oil, another favorite of ours and also a victim of indiscriminate selling that sent prices down some 38 percent, also jumped yesterday, with a 6.6 percent move to $97. Yet oil shares—paper assets—were down. Today, though, many energy stocks jumped even though oil itself fell back $1.50.

Confusing? You bet. Gold and oil are very attractive at these levels, in this crazy economic environment. Goldcorp (GG) is our favorite gold-mining stock. Among the oils, we particularly like ConocoPhillips (COP).

Finally, this week’s financial panic put pressure on financial stocks. Broadly diversified General Electric (GE) also was hit hard because of concerns about its large financial business. We think this week’s weakness presents an excellent buying opportunity, including the chance to lock in a generous yield of almost 5 percent.

Money Fund Safety

This week was also notable for the rapid decline of a large money-market fund, the Reserve Primary Fund. A dozen large investors pulled roughly 65 percent of the fund’s $62 billion of assets after seeing that it held a substantial amount of debt securities from Lehman Brothers, which filed for bankruptcy protection on Monday.

This “run on the bank” forced the Primary Fund to write down the value of the Lehman debt to zero and to "break the buck" as its net asset value sunk below $1 a share to $0.97. This is a no-no and a rare event among money-market funds, which are supposed to be safe, so the news jolted the investment community.

In yet another indication of how self-delusion has become rampant on Wall Street, Bruce Bent, Reserve Management's chief, has long promoted his money funds as paragons of prudent, safe investing. He even appeared on TV just last Friday to criticze money funds that don’t adequately research their investments. Amazingly, he even originated the money-market fund concept back in the 1970s.

Our advice: Use only money funds of large, well-established financial institutions that deal with individual investors. We’ll have more on that in our October issue.

This week’s big news is the federal government’s takeover of Fannie Mae and Freddie Mac. Should the government bail out troubled financial institutions? We’ll leave that debate to the theoreticians, other than to say that this problem was a long time developing and evident to many. Yet the Beltway powers that be chose to look the other way.

We prefer to deal with the way things are and what it means for you. And on that score, we think the bailout was the right thing to do. Fan and Fred’s capital base had shrunk so much, and a collapse of the mortgage titans would have been catastrophic for the global financial system. We believe the government is firmly committed to doing what it can to contain the ongoing financial crisis, regardless of whether some criticize the why and how of it.

Does this solve the problem? Of course not. No one step can eliminate the home-supply glut, foreclosures and weak prices. That will take time and easier lending conditions. But it’s another big step in a long process of stabilizing our broken financial system and the troubled real estate market.

We already see some positive developments. One is the reduced likelihood of serious disruption to the financial markets. Second is lower mortgage rates, now that the government has made its backing of Fannie and Freddie explicit.

Among investors, the big losers are those who held common stock of either company. We can only ask: How could they? The preferred shares have also lost most of their value. There was more justification for keeping the preferred, but quite a few financial institutions held much more than they should have. So much for prudent diversification.

Have there been any winners from the bailout? Yes, the biggest are those who hold Fannie Mae and Freddie Mac debt. These include foreign entities in China, Hong Kong, Japan, Russia, South Korea and Taiwan. Like it or not, when we depend on the kindness of strangers, we need to protect their interests.

You are also a winner if, as we have urged, you own our recommended PIMCO Total Return and Vanguard GNMA mutual funds. The PIMCO fund loaded up on agency mortgages earlier this year because yields were extremely attractive relative to Treasury securities. Vanguard GNMA always invests fully in these top-quality mortgages. Prices of these mortgage securities should climb as their yield spread relative to Treasury securities narrows.

Financial-Stock “Death Watch”

As we write this, speculation is swirling around the fates of Lehman Brothers and Washington Mutual. Wachovia, AIG and Merrill Lynch are on the radar screen too.

Thinking particularly of Lehman and Washington Mutual for now, we wonder what their “leaders” have been doing for the last 15 months. Sitting at the epicenter of the global credit implosion, how could they not have seen and anticipated trouble?

The Lehman Brothers decline is particularly reminiscent of the all-too-recent Bear Stearns debacle last March. Like Bear Stearns, Lehman was considered a street-smart operation and had many opportunities to sell assets, or better yet the whole company, at generous prices. But both firms played their hands too aggressively during good times, failed to recognize changing conditions, and then held off for too long before taking sufficient action to protect their firm, their employees, their customers and their investors.

Naturally, we continue to advise you to avoid most financials. However, the best ones look pretty good at these price levels, led by U.S. Bancorp (USB).

Our Market Outlook: More Optimistic

Consider these recent developments: Oil has tumbled from $147 to near $100. Interest rates have dropped, with 10-year Treasury issues near five-year lows. The dollar has rallied to a 12-month high vs. the euro. Gold has declined 25 percent to below $750 per ounce.

In normal times, all of this would have been considered very bullish and stocks likely would have soared. Not all of these trends are sustainable. Even so, stocks should be up, not down, despite the economy’s ongoing financial problems. Falling energy prices, reduced inflationary pressures and a lower cost of money should mean higher stock prices.

What’s wrong? Well, these obviously aren’t normal times. Even so, the global equity market currently is largely separated from the fundamentals. We see two basic reasons for this.

First, in a market driven by fear and uncertainty, you need to protect your money. So the institutional investors and hedge funds, who are subject to manic-depressive mood swings even though they are supposed to be the “best and the brightest,” have been selling regardless of whether it makes sense to do so.

Second, we believe that this illogical selling is part of an ongoing “deleveraging” process that really started back in February 2007. Since then, the big guys have been pulling back from their wildly excessive use of cheap money as their reckless bets have turned sour. An unfortunate part of this “throw out the baby with the bathwater” mindset is that these investors tend to sell what they can—such as the big, liquid blue chips—instead of what they should—the illiquid junk in their portfolios.

This week’s market performance wasn’t overly encouraging, at least in the short run. After news of the Fannie-Freddie rescue, stocks soared on Monday, but then gave back all their gains, and then some, on Tuesday. On the other hand, the market rallied strongly today from an early sell-off.

Confusion begets volatility. But with the fundamentals improving while we await a return to sanity, our advice to you remains the same. Be careful and conservative. But also take advantage of market weakness to dip lightly into our high-quality recommendations.

Contrary to popular belief, September, not October, historically has been the worst month for stocks. For example, the Dow Jones industrials have finished higher in just 12 of the past 37 Septembers, with an average monthly loss of 1.3 percent, according to the Stock Traders Almanac. The Standard & Poor’s 500 has lost 0.9 percent on average.

That pattern is certainly running true to form already in this month’s first few trading days. The S&P 500 is down about 3.5 percent so far in this holiday-shortened week. Worse, the decline is about 5 percent from the early Tuesday peak to today’s close.

Over time, the best three months for stocks on average have been November, December and January. So this seasonal tendency will soon turn positive again.

For now, though, the major market development is that stocks have been unable to climb despite the continued decline in energy prices. On Tuesday, oil prices tumbled after Hurricane Gustav caused no major damage to energy facilities on the Gulf Coast. But the Dow, which had been up nearly 300 points in early trading, actually ended down for the day. Then the Dow tumbled another 345 points today despite continued energy-price weakness. And the news in foreign markets has been no better.

In a nutshell, the muted summer stock-market rally fueled by sinking oil prices has been replaced by anxiety about the global economy. One possible interpretation is that the dramatic spike in oil and commodities earlier this year had already hit global growth hard. Fears of a worldwide economic slowdown, which have driven down the price of oil about 26 percent from its July peak, more recently have also been weighing on the shares of large multinationals in many businesses that have benefited from strong exports.

To put it another way, the inability of the broad market to mount a sustained rally in the face of what should be good news on the commodity and inflation fronts sends an emphatically negative message as least for the short term. Still, the global equities markets are merely retesting their lows of mid July. Unpleasant, but not surprising.

So our advice to you is to stay cautious and conservative overall while using a modest portion of your cash reserves to take advantage of the current widespread price weakness.

Slowing Global Growth

The message of the markets unfortunately is echoed by predictions of slower growth around the world.

In the U.S., the Federal Reserve said this week that economic conditions remain “weak, soft or subdued” across the country, based on reports from the twelve Federal Reserve Districts. The basic theme is stagflation—sluggish growth with high inflation. Weak consumer spending makes it virtually certain the Fed will keep short-term interest rates unchanged at 2 percent later this month and probably for at least the rest of 2008.

Meanwhile, the rest of the so-called developed markets—Western Europe and Japan—appear to be having an even tougher time.

Today, both the European Central Bank and the Bank of England left interest rates steady, despite sagging growth. And Japan’s prime minister resigned this week less than a year into his term, prolonging a political deadlock as the world’s second-largest economy struggles to avoid recession amid significant structural obstacles. The next prime minister will be Japan’s fourth leader since 2006.

What’s more, the Organization for Economic Cooperation and Development has just lowered its forecast for economic growth in the major European economies and Japan. The 15-nation euro zone now is expected to grow 1.3 percent this year, compared with 1.7 percent forecast in June. Japan will grow by just 1.2 percent, down from June's 1.7 percent, the OECD predicted. The agency also said it expects the U.S. economy to grow 1.8 percent, revised up from 1.2 percent.

Bring Some Dollars Back Home

So, despite the gloom and doom here in the U.S., the dollar is continuing to climb against the pound and euro. The greenback is now at a 2-1/2-year peak against the pound and today touched its 2008 high vs. the euro.

Overall, we view a strong currency as a positive for a nation’s economy. But the dollar strength lately has worsened returns to U.S. investors from weak international markets.

Currency fluctuations can play a big role in your returns. U.S. investors effectively convert dollars into local currencies when they buy, then shift back to dollars when they sell. The MSCI EAFE Index, a developed-markets benchmark, has returned 14 percent on average over the past five years in dollar terms, but only 6.8 percent return in local currencies. U.S. investors poured an estimated $300 billion into international equity mutual funds during that period while steadily pulling cash out of U.S. stock funds.

Has the buck entered a new bull market? Too soon to say. But we believe it’s particularly undervalued vs. the euro, as we’ve advised you several times in recent months. At the very least, the dollar’s strength, combined with slower growth in Britain, Europe and Japan than here, presents a persuasive case for at least cutting back on some of your non-U.S. investments and bringing more of your dollars home.

Stocks climbed today after a stronger-than-expected reading on the U.S. economy. U.S. stocks are up slightly in the week since our last update to you.

The economy grew at a solid if unspectacular 3.3 percent annual rate April through June, compared with the original estimate of 1.9 percent. This report reinforces our longstanding view that the U.S. economy is not in a recession, contrary to the opinions of all too many alleged experts.

The primary engine of growth has been exports, which rose at a 13.2 percent annual rate. But growth is slowing overseas, and the dollar has stabilized, which could dampen exports and growth in the current quarter. Second-quarter consumer spending by consumers climbed 1.7 percent, aided by tax rebates. Consumer spending accounts for about 70 percent of the economy.

With growth stronger on the business and export sides of the economy and weaker on the consumer side, we continue to advise avoiding investments that depend on consumer spending.

The Dollar Is on the Rebound

This week was also notable for the continuing dollar rally from its all-time lows in July. Over the last six weeks, the dollar has advanced strongly against the other currencies of the major developed nations. Most notable is the gain of roughly 9 percent vs. the British pound and 8 percent against the euro. Little noticed, the greenback actually bottomed back in February vs. the euro, and it has just hit a two-year high against the pound.

What’s the story? While the economic problems of the U.S. grabbed the headlines, Western Europe and the U.K. likely have slipped into a recession. After all, energy prices are much higher there than in the U.S. The euro has long been overvalued, hurting exports. And credit shocks have been significant too, fueled by the decline of overheated housing markets. Plus, government and corporate debt is particularly high in some of the euro nations. The Bank of England and the European Central Bank likely will have to cut interest rates as growth continues to deteriorate and inflation—they hope—starts to moderate. The dollar has already been punished for U.S. economic woes and a sharp interest-rate cut. Now it may be Europe’s turn.

Then there’s purchasing power parity. This is basically the relative cost, after adjusting for exchange rates, of identical goods in various nations around the world. Examples include an Apple iPod, a Hermes scarf and a McDonald’s Big Mac. Using that measure, the dollar remains significantly undervalued and the euro wildly overvalued, even after taking into account the dollar’s recent rally.

Home Prices: Worst May Be Over…

Home prices and sales are finally starting to show signs of stability, according to three reports issued this week.

First, the bad news: Home values dropped 15.9 percent in the 12 months through June, by one measure. That’s the S&P/Case-Shiller National Home Price Index, generally considered the most reliable indicator of American home values. It covers previously owned single-family homes in 20 major metropolitan areas.

The not-so-bad news: Prices fell at a slower pace for the fourth straight month in June, with prices down 0.5 percent for the month compared with 2 percent monthly drops earlier this year. And in June, nine of the 20 metro areas actually showed a gain, up from seven in May. One other report indicated slow new-home sales, but up from the previous month’s pace, which was at a 17-year low. The third report suggested a pickup in sales of foreclosed homes, sold at steep discounts.

Indications are that the big price declines are behind us, but that the housing market nationwide hasn’t hit bottom yet. For one thing, inventories remain exceptionally high. Or to put it another way, prices in the stronger areas have stabilized while those in the weak areas are still under heavy pressure. Another obstacle is that mortgage rates rose this summer as lenders have continued to tighten their standards.

The bottom line: Prices are steadying, but they’re unlikely to recover quickly. Even so, real estate is heavily oriented towards local conditions. If you need to sell, it’s essential that you price your home realistically and put it in “move-in” condition. If you don’t need to sell now, don’t bother putting it on the market. If you’re a buyer, this is an excellent time to buy in most markets.

…But They’re Mailing Back the Keys

With home prices still weak and foreclosures increasing, home ownership apparently isn’t the priority it used to be. People are more willing to give up their homes than they were during previous economic and housing downturns.

It used to be that homeowners continued to make their mortgage payments as long as possible, even if they had to cut other spending. But now an increasing number of distressed owners are defaulting on their mortgage payments and giving up their homes while continuing to service other debt. For people who either used little of their own money to buy a home and/or who have racked up too much other debt, sending back the keys could be a perfectly reasonable decision. There are even companies specializing in “helping” people unload their homes. “What if you could live payment-free for up to eight months or more and walk away without owing a penny?” one website asks.

Traditionally, you paid your mortgage first, your auto loan second, and then your utilities and phone bill, followed by other obligations. Now, with many homes still losing value, more owners are less motivated to repay their mortgages. Instead, they’re focusing on eating and other “necessities,” so they need to keep their credit cards open. For them credit is more important than home ownership.

First, bull or bear? Since our last weekly update to you, the broad stock market has climbed two days, dropped the next two days, and then rose today. The Standard & Poor's 500 index is up 2 percent for the week ending Thursday and about 6.5 percent from its low a month ago. Not bad, but the volatility continues and the trend has been erratic. In short, frustrating to bulls and bears alike.

The current market advance was inevitable because of the fast drop that preceded it, setting up a deeply oversold situation. Inevitably, the rally has been fueled largely by a sharp decline in oil and other commodities, which was also inevitable because of a heavily overbought condition following a rapid run up in those markets.

For now, it’s still too soon to say that either the broad stock market or commodities have broken out of their longer-term trends. For most stocks, the path of least resistance remains flat to down. For oil and other commodities, the long-term trend is still up. So stay cautious and patient.

Growth or recession? The answer to this one is easier. Our economy is still growing, despite all of the cries from experts, or rather economists, that a downturn was inevitable. Regardless of whether a recession does occur, it’s largely an academic issue.

You see, economic growth overall in the U.S. throughout this decade has been better than the pundits predicted, although hardly robust. What has gone into recession is the national mood. That downturn, in fact, started even before 9/11. And now that consumers are getting squeezed from all sides, it seems, that pessimism seems more justifiable on Main Street. The negative mindset is in full force on Wall Street too.

But we’re still growing, albeit slowly. And business is still pretty good for some parts of our economy: U.S. exports have jumped 21 percent in the last year.

Recession or not according to the numbers, it feels like one to most people. And that’s what counts.

Amid gloom, doom and skepticism, your best bet from a timing standpoint now is to buy very selectively on weakness and sell on strength. Not the other way around.

Now, here’s the third Q&A….

Inflation or Deflation?

Today’s government inflation report, with its dubious merits from an accuracy standpoint, is that the consumer price index rose 0.8 percent in July, and 0.3 percent on a “core” basis, excluding food and energy. In the last 12 months, the numbers are 5.6 percent and 2.5 percent respectively.

You probably won’t disagree with our view that even the higher numbers understate the inflation situation. Maybe we’re biased. But we just cruised through the supermarket and paid a college tuition bill that was 11 percent higher than last year’s. We tend to believe our own eyes and ears more than doctored government reports.

Yet it’s deflation, or at least the risk of anemic economic growth, that’s the bigger problem. The Federal Reserve has basically signaled that, and we agree. Job losses and income growth that lags inflation are continuing to dampen consumer spending, which in turn showed up in yesterday’s sluggish retail sales report.

And Then There’s the Credit Crunch

Last summer, it came to light that all too many of the mortgages that had been repackaged into securities and sold all over the world basically weren’t worth the paper they were printed on. Now, a year later, the market for securitization, through which mortgages and other debts are packaged and sold as securities, remains badly broken. It’s no surprise that the institutional investors who bought those securities—in many cases without bothering to investigate what they contained—are not eager to buy more.

As a result, the availability of mortgages for homes and commercial properties and of loans for college and autos is much tighter than it was a year ago. This has occurred even though demand for mortgages and other credit has declined because of the sluggish economy. And if you can get the credit you need, you’ll pay a higher interest rate even though rates on U.S. Treasury securities have dropped sharply since last summer as the Federal Reserve slashed its benchmark rate from 5.25 percent to 2 percent. So much for supply and demand.

Ed Yardeni, an astute observer who coined the term “bond vigilantes” back in the 1980s, put it this way: “The bond vigilantes took law and order in their own hands and pushed yields up, which would slow down the economy and bring down inflation,” he says. “This time the bond credit vigilantes are refusing to go into the saloon and start drinking what Wall Street’s financial engineers are mixing.”

The economy will remain sluggish and the broad financial market likely will stay in a trading range until the hangover begins to wear off and the credit elixir starts flowing more freely again.

2 Timely Opportunities

Despite the sluggish economic environment and risk-averse investment environment, we’re more optimistic for the long haul than our analysis above might suggest. But our key message to you for now is the importance of staying conservative and sticking with high-quality assets.

For income investors, we advise taking advantage of the mortgage credit crunch by investing in AAA government-backed mortgages. Our two recommended bond funds here are Vanguard GNMA (VFIIX) and PIMCO Total Return (PTTDX). The Vanguard fund invests exclusively in government-backed mortgages. The PIMCO fund recently had a 61 percent stake there, plus 22 percent in cash. Both funds yield about 5 percent.

For growth and income, it’s hard to beat Johnson & Johnson for the long haul. Its diversity, by both product and market, makes it a safe haven in tough times. Growth has recently accelerated because of strength in medical devices and consumer products. Current yield: 2.6 percent.

U.S. House of Representatives has passed legislation designed to bail out Freddie Mac and Fannie Mae. Next stop is the U.S. Senate, which is also expected to greenlight the move. President Bush has signaled his intention to sign into law the rescue plan for the ailing companies, which together own or guarantee roughly half of the nation’s outstanding mortgages. In their absence the mortgage market would essentially shut down.

The House bill gives the U.S. Treasury Secretary power to purchase an unlimited amount of stock in the pair, as well as a provision to insure as much as $300 billion of refinanced mortgages for homeowners. As part of the bill’s reform measures, there will be greater government oversight of Fannie and Freddie and the Federal Reserve will play a role supervising the duo’s capital.

Although we’ll only know with the benefit of hindsight, this bailout most likely will lead mark the turning point in the house sector’s downturn and the country’s credit crunch. We can’t help but draw parallels to the creation of the Resolution Trust Corporation in the wake of the Savings & Loan crisis a generation ago. From that point, stocks in the sector began to recover, in many cases posting spectacular returns.

That’s not to say we would purchase either Fannie or Freddie’s stock here. But it means we should see the restoration in confidence in the financial sector overall. At least that’s our hope.

The real concern is that the bailout doesn’t stem the tide and that the credit crunch drags on, all the while getting worse. Having already cut short-term interest rates to well below the inflation rate, and having opened the Fed’s emergency lending window to not just banks but broker/dealers as well, there’s not much more the authorities can do beyond the expected massive bailout of the two government service enterprises.

Already expectations are that inflation-adjusted short-term interest rates will remain negative well into 2009. The Federal Reserve has little choice but to let inflation gain even more momentum in the months ahead. And on the plus side, given enough inflation real estate will start to look like an attractive asset class again, thereby ending the vicious downward spiral in housing prices.

A Picture Worth 12,000 Words

Energy prices have dropped sharply in the last few weeks. Now we’re hearing one commentator after another rushing to declare that crude oil prices are soon headed for $80 a barrel. While prices could no doubt fall further from here, we think the demise of the oil bull market is greatly exaggerated. A simple chart tells the story quite well.

The graph below was taken from the Interagency Task Force’s Interim Report on Crude Oil. The Task Force includes members from the Commodity Futures Trading Commission and several Federal agencies and was set up to examine the effect speculators were having on crude oil futures prices. 

The conclusion of the Task Force’s 45-page, 12,000-word report was that speculators we’re not driving the price of oil. The real culprit is good old-fashioned supply and demand. Global growth has been on a tear in recent years, and should climb by more than 4 percent this year. That growth has required oil, a lot of it. The supply of oil, however, has not kept pace. Nor will we see a significant increase in production in the coming year.

For oil prices to continue falling, and to stay below $100 for a sustained period, will require a major global downturn in growth. And the weight of evidence suggests that’s not going to happen anytime soon.

The High Cost of Low Living

What with the action in the stock market in the past year you’ll be forgiven for turning to some crutch or other to soften the pain. If booze is your poison, it seems you’re soon going to pay a higher price to indulge your vice.

Yesterday, Anhueser-Busch Companies, the nation’s largest brewer, announced that it was raising the price every Joe Sixpack will pay for a case of brew effective this fall. It seems the parent of the King of Beers no longer wants to absorb the rising cost of barley and hops on its own and it plans to pass along those costs at an accelerated pace in the months that follow. Bud shareholders, at least, will get a break in the form of the company’s 12 percent hike in its dividend. Bud’s move in price increase is likely to be followed by other brewers. Diageo, the world’s largest maker of premium brands of liquor, is also upping prices for its goods worldwide to offset production costs.

Maybe these increases will make the Fed’s Board of Governors sit up and take notice the next time we get a big jump in the food (and beverage) component on the Consumer Price Index. Cheers.

After eight straight days of gains, the Dow Industrials took a well deserved break, but not before touching on the xx-week high. Similarly, the S&P 500’s yesterday close was the highest since kjhkjh.

The market action in the last few days indicates that the worries about the economy did not abate yet. While the reading on the U.S. Gross Domestic Product (GDP) beat expectations of the 1.5 percent decline, it still showed that our economy declined 1 percent over the course of the second quarter of 2009.

Of course, this is a much better number than the 6.4 percent decline in real GDP in the first quarter of the year. Nevertheless, it shows that the U.S. economy is now 3.9 percent smaller than it was a year ago. This quarter’s decline in GDP is the fourth-in-a-row, making this economic contraction the longest since the government started keeping quarterly records in 1947.

Indeed, the decline while smaller is still very painful – as job losses also assert. Most economists still expect double-digit unemployment as job losses, while leveling out, aren’t improving. One of direct results of that is the decline in real personal consumption. Consumers spent 1 percent less in the second quarter; in contrast, our collective spending had increased 0.6 percent in the first.

This last quarter, improvements in the U.S. economy translated to much smaller decreases in nonresidential fixed investment and in exports, an upturn in the order of 11 percent in federal government spending, smaller decreases in private inventory investment and residential fixed investment, and an upturn in state and local government spending.

If this economic cycle works the way other cycles did, at some point in the future the business inventory reduction will stop as and the companies will start increasing production. Cyclical upswing in business spending will eventually respond to monetary and fiscal policies. So far, businesses continue to reduce inventories and cut costs.

Eventually, even modest growth in the U.S. could be followed by the price increase. So far, we are in the sweet spot with regards to inflation. So far, prices paid by U.S. residents, increased 0.5 percent in the second quarter, 0.2 percentage point less than in the advance estimate (in the first quarter, prices decreased 1.4 percent). Excluding food and energy prices, the price index for gross domestic purchases increased 0.8 percent in the second quarter, compared with an increase of 0.2 percent in the first. Barred another economic accident, the prospects of deflation seem to be diminishing. 

Don't Change Horses in Mid Stream  

The case for continued deflation includes the contracting economy with banks unwilling to step up the pace of lending, the weak housing market and the prospect that the rebound, when it occurs, will be milder than in past recessions as consumers look to boost their savings and pay down debt.

The inflation case is also quite compelling. We’ve seen a doubling in the monetary base in the past seven months to tackle the financial crisis and with the Federal Reserve’s ballooning balance sheet chock full of agency debt, mortgage-backed and other paper that isn’t Treasury securities, Chairman Bernanke’s promise to remove the excess liquidity when the need arises rings hollow. Housing affordability, meanwhile, has risen to the highest levels since records have been kept. At some point, probably sooner rather than later, the excess inventory in housing is going to get sopped up.

And then there’s growth outside of the U.S., in the emerging economies that now make up half of the world’s output. China, in particular, appears to be doing okay. The rate of growth there has slowed, but it’s not contracting (thanks to aggressive stimulus spending).  

Bank troubles

The U.S. added 111 lenders to its list of “problem banks” in the second quarter, a 36 percent increase, that pushed that to the highest levels since 1994, the S&L crisis.

The Obama administration recently announced the U.S. budget deficit will be $9 trillion during the next decade; $2 trillion higher than the original forecast.

Unemployment

China 

Bernanke renomination

(OLD UPDATE) Despite this year's broad-based decline in both the economy and the financial markets, President Obama still has widespread popular support. But many economists give Obama and Treasury Secretary Timothy Geithner failing grades for their efforts to revive the banking system, according to a recent survey. We place little faith in most economic commentary. After all, economics is known as the "dismal science" primarily for its notorious forecasting inaccuracy. The financial-system problem is huge and complex. And the financial markets all too often demand instant gratification.

Even so, the delay in implementing a sound bank-rescue plan is troubling. After all, the Treasury Secretary has been very close to the action for a long time, first as president of the Federal Reserve Bank of New York during the time when the financial problems were mounting, then as the federal government started to address those problems.

Yet it's a matter of when, not if or by what methods, the banking crisis will end. It probably will require an incomprehensible amount of money, much of it badly spent. But that's the nature of huge undertakings, and this is one of the biggest. In other words, there will be a lot more spending to do.

The Federal Reserve is living up to its promise to do whatever it can to get the economy going again. Catching the financial markets completely by surprise, the Fed stepped up that effort in a big way yesterday with the announcement that it will pump another $1.15 trillion into the financial system by purchasing U.S. Treasury issues and mortgage securities.

The Fed said it will buy $300 billion of Treasury securities, mostly in the two-to-10-year maturity range; increase its purchase of mortgage-backed securities from $500 billion to $1.25 trillion; and double its purchase of debt from government agencies to $200 billion.

The Fed previously had cut its benchmark short-term interest rate to near zero. But the economy is still weak and credit conditions remain tight. This latest, aggressive move is designed to raise the supply of credit and push down borrowing costs of mortgages and other types of loans. Despite an unprecedented increase in the money supply, lenders remain unwilling to lend and borrowers unwilling or unable to borrow so much of that money is lying dormant. So the Fed, in effect, increasingly is acting as a lender in its own right.

After some profit taking on Tuesday, stocks resumed their advance on Wednesday and Thursday. At least for now, though, the stock market is getting what it wants: signs of progress. In addition to the recent announcements by the Treasury and the Federal Reserve of new, aggressive moves on the economy, the good news (or at least not bad news) includes improvements in sales of existing homes and new-home construction starts, albeit from deeply depressed levels.

The next major test for the stock market will be how well it survives bad news, or to put it another way, news that's considerably worse than expected. And bad news doubtless will come.

At this point, it's still soon to go out on a limb and say the worst is definitely over. It's easy for the bears to say that the worst is yet to come—that the economy will stay weak indefinitely, banks will fail and earnings will “surprise on the downside.”

Our view is more measured, more moderate. Inevitably, a pullback will occur. So will tests and re-tests of prior lows. This is why our advice, in place for several months now, remains the same: Buy high-quality investment assets on market weakness. This enables you to enjoy the rallies and weather the declines.

(OLD ENDS)   

World stock markets declined sharply Monday. The trouble started in Shanghai, where the benchmark index fell 5.8 percent, its biggest loss since November. The Dow Jones industrial average's 2 percent decline that day actually understated the weakness here in the U.S.

The widely stated reason for the tumble was renewed worries about the strength of the global economic recovery. But there doesn't have to be an official reason. In our view, it was simply a matter of overdue profit taking.

After all, news on the economy has actually been improving. And the profit taking lasted just one day. U.S. stocks have since made up for Monday's lost ground. At today's market close, the S&P 500 was actually slightly higher than its closing level last Friday. 

Treasury Crosscurrents, Dollar Headwinds

Our long-term view for both U.S. Treasury securities and the dollar is unfavorable. In both cases, it reflects concerns about the massive amount of debt in the U.S., exacerbated by the necessary but costly government programs to bail out the troubled economy and financial system. This makes our government debt securities and our currency relatively unattractive. 

For Treasury issues, there are also worries about the large quantity of them held by foreign investors. It's generally in the interest of these investors to support their large Treasury stakes. But there are also signs that they want to diversify away from Treasury issues, and that they won't be as willing to buy as much as before even as new issuance will jump in order to fund our mounting debt.

But sometimes short-term trends run counter to the long-term ones.

China and Japan, the world's largest creditors to the U.S., bought longer-term Treasury notes and bonds at a record rate in June. It's also worth noting that demand for Treasury securities has risen from U.S. households, which have finally started to save more after years of spendthrift behavior.

China and Japan were heavy sellers of short-term T-bills in June. But total foreign net buying of Treasurys excluding Treasury bills hit $100.5 billion in June.

So while we continue to worry that the U.S. government's aggressive stimulus program will eventually fuel inflation, this is not yet a major concern for foreign buyers.

In June, yields on Treasury notes and bonds hit their highest levels for the year, with the 10-year yield briefly climbing above 4 percent. That yield has now fallen to below 3.5 percent amid strong buying. Yet investors supposedly are turning more bearish on Treasuries based on the belief that yields will rise (will lower prices) as the economy gradually improves

Meanwhile, the dollar benefited in 2008 as a safe haven amid a risk-averse, global flight to quality during the economic crisis. But as the world's investors regain a taste of risk, they tend to move out of dollars and into other vehicles that offer better profit potential, particularly in a recovering economic environment.

For the dollar, the direction is more clear: down. While demand for Treasury issues has remained relatively strong despite perceived economic improvement, that same factor is putting pressure on the greenback

The Dollar Index, which the Intercontinental Exchange (a publicly traded global electronic marketplace) uses to track the dollar against six major currencies, is now at its lowest level in almost a year. Stronger economic data tend to weaken the dollar as investors became more comfortable buying riskier, higher-yielding assets elsewhere.

A potential catalyst for a higher dollar would be if the Federal Reserve were to start raising short-term interest rates again. But that's not in the cards yet. 

U.S. Lags Budding Global Recovery

The big picture for the world's economy is this. First, many emerging-markets economies are doing well. Second, the economies of many more mature nations stabilized in the second quarter. The U.S., however, continues to lag, although growth is expected to return in the current quarter.

The Organization for Economic Cooperation and Development said this week that its 30 members, developed-market nations, collectively should start to grow sooner than previously expected. But the group's economic recovery will probably still be weak.

The OECD said its member countries stabilized in the second quarter, led by export growth in Germany and Japan. The OECD's report said that gross domestic product (GDP) of the OECD's major seven countries (Canada, France, Germany, Italy, the U.S., the U.K. and Japan) slipped 0.1 percent from the previous quarter between April and June after dropping 2.1 percent in the first quarter. The U.K. and Italy lagged the most behind, followed by the U.S. at a 0.3 percent drop.

The outlook from Europe, where the OECD is based, is much the same as it is here. For example, the International Chamber of Commerce there said that high unemployment rates and rising public debt in many countries bring concerns about a sustained recovery in the global economy.

One of the keys to successful investing is to not let emotion get in the way of your decision making. Of course that’s easier said then done—especially when stocks are falling and you’re seemingly getting hit with one bad piece of news after the other. But it can be done.

Like all other crises before it, the current financial crisis is without a doubt creating a good buying opportunity for investors with the courage to step up and buy. We can’t rule out prices falling more in the short run, but chances are the major averages will hold above their August lows. And we don’t simply advocate buying just any old shares. Instead, we would stick with high-quality companies selling at reasonable valuations.

Although the economy is slowing and the housing market’s woes are likely to drag on through 2008, the problems in the financial sector can be fixed by throwing enough money at it. And that’s precisely what the Federal Reserve is doing by trimming interest rates.

Bernanke and Company have already cut rates several times and traders are overwhelmingly expecting another rate cut when the Fed’s Open Market Committee meets again in December. Expectations are divided between a quarter or a half point decline in the Fed’s discount rate, but the majority is leaning toward the larger cut.

One sign that we’re near a bottom can be seen in the difference between the stocks and bonds issued by Freddie Mac and Fannie Mae. These mortgage finance institutions have the implicit backing of the U.S. government. Their share prices have plummeted in recent trading, dropping nearly 60 percent each in the last six weeks due to asset losses and a cloudy outlook on sub-prime loans.

However, bonds issued by the two companies (these are simply repackaged mortgages) have been unaffected by the crisis. Keep in mind that we’re not recommending purchasing either Freddie or Fannie, as better opportunities exist. But the action in their share prices suggests we’re near the point of maximum pain in this crisis.

Check out the Income Performance Portfolio for our favorites in the battered financial sector.

Another sign of investor panic can be seen in the credit market. Yields on 10-year Treasurys are at two-year lows right now, hovering just above 4 percent. That’s a full percentage point below what you can earn by keeping your money in some money market funds. With the Consumer Price Index at 3.5 percent (and accelerating) and the true inflation rate much higher, investing in Treasury bonds right now is a fool’s game, unless you’re convinced long-term rates are headed much lower. We wouldn’t count on it.

Of course the meager interest your cash will generate if held in an interest-bearing account will invariably lose to inflation, too. This is a battle that will only get bloodier as inflation accelerates. That’s because banks simply won’t pay you more than they can earn on your money—and that earning power is limited by inflation. Let’s not forget the government will also want a piece of the action: The interest generated on your cash will typically be taxed as ordinary income in the year when it was earned. So as an asset class cash is a non-starter.

But enough about finance and investments. We would like to wish you a safe and happy Thanksgiving.

Want to avoid direct communication? A new technology, aptly called Slydial, allows you to jump directly to phone voice mail without having to risk talking to the person on the other end. So you get the benefit of using “personal communication”—instead of impersonal e-mail or text messaging, say—without actually talking to someone and perhaps having to dodge unpleasant questions.

We’ll leave it to you to consider the possibilities.

But we see Slydial as an unfortunate yet logical development in an era when it seems that fewer people say what they mean, mean what they say and fully acknowledge responsibility for their actions.

That’s one of the reasons we focus on the “message of the markets.” We’ve found that the markets, in their collective wisdom, are much more relevant to making money and protecting capital than what government leaders, corporate CEOs or market pundits have to say.

To be sure, reading the message of the markets is an art, not a science, because the markets reflect the constant ebb and flow of human nature—and the inevitable swings among optimism, pessimism and that big area in between. What’s more, these are challenging times, to say the least.

This week, for instance, stocks soared on Tuesday to their biggest one-day advance in four months on reassuring signals from the Federal Reserve and plunging commodity prices. But then worries about the economy and financial system took back the spotlight.

Here’s the message as we see it. The stock market is in the midst of its fourth rally attempt since peaking last October. It’s too soon to say if this one will last longer than the previous three. Valuations overall are very attractive. And corporate earnings have held up pretty well outside the troubled financial sector. But the reality is that the broad market still has a negative bias, and investors rightly remain skeptical.

The bottom line: When a sustainable advance develops, there will be plenty of time for you to profit. For now, stay cautious and conservative, but take advantage of opportunities we see developing now. More on that below.

Oil Is Down But Not Out

Oil prices were down roughly 20 percent from their all-time high of less than a month ago before rebounding modestly today. Does this mean the “oil bubble” is bursting, as some market commentators have been speculating lately?

No. That’s little more than wishful thinking, in our view.

As we’ve often advised, the basic global supply-demand picture for energy makes it very difficult to see a bubble, much less the bursting of one. It’s getting increasingly difficult and costly to find and develop new sources of supply. Meanwhile, on a global basis demand will continue to build steadily over the long term, regardless of a possible slowdown from the U.S. and Western Europe.

To be sure, the energy market was overdue for an inevitable and much-needed pullback after its stunning runup from February to July. And the correction could continue for a while in time and price and still be within the framework of a long-term bull market, as we point out in our current issue of Leeb’s Income Performance Letter. Periodic, sharp declines are typical in commodities bull markets.

So this is a good time to take advantage of current market weakness, and start to build or add to your stake in our two recommended high-yield energy trusts: San Juan Royalty Trust (SJT) and Hugoton Royalty Trust (HGT). Both carry double-digit, inflation-beating yields.

Stay Careful with the Financials

The news coming out of Freddie Mac and American International Group this week, to cite just two of many examples in the deeply distressed financial sector, reinforces the importance of treading lightly and sticking only with high quality in troubled parts of the economy and financial markets.

Freddie Mac, the government-sponsored provider of funds for home mortgages, reported its second straight quarterly loss that was much bigger than expected. Freddie also slashed its dividend for the second time in nine months and said it expects further losses for the rest of the year amid rising mortgage defaults and weak home prices. Freddie Mac’s stock has gone from $60 to as low as under $4 since last October.

AIG also reported a much worse-than-forecast loss, primarily because of a big mortgage-related write-down. It was the company's third consecutive multibillion-dollar quarterly loss. At its recent low, AIG shares were down 80 percent from their all-time high seven years ago.

Financial stocks led the way in Tuesday’s big advance as investors cheered what actually has been evident for quite a while: The Fed can’t and won’t boost interest rates in a weak economy with a troubled financial system. Financials benefit the most from low rates.

By Thursday, though, the crowd was more focused on the many negative reasons that short-term interest rates will stay below inflation for a while. Start with the weak housing market, rising unemployment and sluggish wage growth, all of which hit consumers particularly hard, crimping their ability and willingness to borrow.

Then add tight credit conditions. Amazingly, rates on standard 30-year fixed mortgages, at about 6.5 percent, are higher than they were a year ago, to cite just one example. All of this hurts the economy—but particularly the financial sector.

So stick with the best and forget the rest. JPMorgan Chase (JPM) and U.S. Bancorp (USB), our two favorite financials, inevitably have had some problems, but they’ve been modest compared with the financial group overall. JPM and USB will survive and ultimately thrive. Meanwhile, you’ll collect good yields of 3.6 percent and 5.3 percent respectively.

Market sentiment has clearly improved now that we’re almost through with earnings season. Of course, lower oil has something to do with it as well. The debate on whether or not the U.S. economy is actually in a recession, in the meantime, continues.

This morning, the Department of Commerce released a preliminary report on second quarter GDP. According to the report, the GDP grew at an annual rate of 1.9 percent in the second quarter, up from the 0.9 percent growth rate the economy experienced in the first quarter of the year. The economy continues to chug along; the numbers show that its growth is undeniable although somewhat weaker than anticipated 2.3 percent.

So are we in a recession or are we not? Technically, a recession is defined as two consecutive quarters of negative economic growth as measured by a country's GDP. But the National Bureau of Economic Research, which determines if and when the economy is actually in a recession, doesn’t focus solely on GDP. It considers a variety of economic measures, including employment, sales, incomes, inflation, etc.

And while GDP for the prior two quarters was revised down, today’s positive number confirms our conviction that we are not in a recession. Nor do we feel that we are progressing into a recession that will feed on itself in a downward spiral. While the housing and financial sectors stagnate, other segments of the economy, including manufacturing, are doing ok.

Good Side of the Lower Dollar

Not to be overlooked, better than expected durable goods report last Friday helped to ease some concerns about the slowdown. While economists have forecasted a decline, the orders for durable goods, those products made to last several years, increased 0.8% and posted their first consecutive monthly increase since July 2007.

The weaker dollar has also helped U.S. manufacturers sell abroad, as American-made products have become cheaper overseas, and helped in reaching record export levels.

However, while a weak dollar can increase the competitiveness of U.S. companies selling abroad as well as U.S. tourism, it can still pose a threat. Most importantly, a weak dollar is inflationary, since it increases the cost of imports. Also, there is a dollar-oil price relationship, as oil is priced in dollars and weakness in the currency compounds problems caused by supply/demand imbalance.

Of course, this also means that goods which American consumers buy from overseas become more expensive. So if you happen to have a taste for Italian shoes or French wine, you’re going to have to start dishing out more dough for them. Thus, a weaker dollar can bring about a decrease in the real spending power of U.S. consumers, while the opposite applies with a strong dollar.

Of course, for most Americans, a weak dollar is always a cause for concern.

Over the long term, the value of a country's currency is seen as an indication of the overall health of its economy and perhaps its standing in the world. But despite the negatives an anemic U.S. dollar can bring about, there are certainly some positives as well.

How to Put an End to Foreclosures…

More and more measures are being taken to save the housing market from further tumbling into the huge sinkhole first caused by overlending. Yesterday, President Bush signed a housing bill which he had once threatened to veto. The bill is intended to save about 15 percent of homeowners confronted with the possibility of foreclosure and is considered by many to be possibly one of the most important housing bills signed in decades.

It has been estimated that approximately 3 million homeowners could possibly end up losing their homes to foreclosures by the end of next year. Under this new bill, around 400,000 of those homeowners having trouble making their mortgage payments could steer clear of foreclosure by trading in their old loans for new, more affordable mortgages with help from the FHA. The only stipulation is that the homeowner’s bank must agree to the swap and tolerate taking a loss in exchange for avoiding the hassle of foreclosure. In order to qualify for this program, a homeowner must putt more than 30 percent of their income toward their mortgage and be able to show that they have the means to make payments on their new FHA loan. If all goes according to plan, the legislation should help combat the growing housing crisis and hopefully improve confidence and stability in U.S. markets.

Putting an end to the housing slump and keeping worthy American families in their homes are admirable goals; together with heroic measures to save Fannie and Freddie from collapse the bill’s passing indicates that all possible measures to save the economy are being considered. And while more government spending is inflationary, more disasters in housing and banking are not good for the economy either.

Man, what a week! In case you’ve spent the past week digging your toes into the sand at the beach (which, to be honest, sounds far more inviting than the week we spent with our noses buried in our Bloomberg terminals), there has been enough action in the last few days to last several months.

Prior to yesterday the financial sector had been under intense pressure. “Adequately capitalized” had quickly become the buzzword when talking about companies, and the term was seemingly mentioned most often with companies that were in the worst shape.

Shareholders were bailing out of Fannie Mae and Freddie Mac in droves following questions over whether the government service enterprises (GSEs) were…you guessed it…adequately capitalized. Since the pair is the only real secondary market for home mortgage loans, the government stepped up and all but nationalized them. Fannie and Freddie’s shareholders are probably toast, but the duo’s AAA credit rating has been saved.

As a side note, we don’t toot our own horn very often, but we’ll remind you that we warned against buying Fannie Mae and Freddie Mac in the January issue. To many the pair looked cheap at the time, but we viewed them as being value traps. They have since lost about three quarters of their value.

As the mortgage GSEs were plummeting this past week, the banking sector received another jolt with the failure of California-based IndyMac Bancorp. The news, coupled with images of long lines of customers rushing to get their savings out of IndyMac prompted a sharp selloff in bank stocks of all stripes, regardless of their fundamentals.

Adding to the excitement, Fed Chairman Ben Bernanke was doing his semi-annual stint before Congressional banking committees. Some Fed officials as recently as June had been anxious to raise interest rates to keep inflation in check. But Big Ben conceded this week that despite inflationary pressure, monetary policy is essentially frozen where it is now for the time being to combat slow growth and weakness in the financial sector.

With the Fed’s hands tied the U.S. dollar was bumping along at a record low against the euro. Then, just as Bernanke was clearing his throat to answer senators’ questions, an interesting thing occurred. In the span of just a few minutes, oil prices plummeted, the dollar shot up and stocks started to rebound. No one is saying (at least publicly) that there was a concerted effort to intervene in the markets, but it sure had the feel of one.

Market sentiment has since become much more positive now that several banks have reported their second-quarter results. US Bancorp kicked things off with good, but not outstanding numbers. They were followed by Wells Fargo, which not only reported excellent numbers but went a step further by hiking their dividend. Today we heard from J.P. Morgan Chase, which beat expectations on both its top and bottom line numbers.

Keep in mind that more write-offs will no doubt be reported from the banking sector in the coming quarters. But bank and broker/deal borrowings from the Fed are lighter now than it was in March. The housing sector, meanwhile, hasn’t materially deteriorated in the last several months.

We may not have seen the bottom in the banking sector just yet, but with the group trading at less than 10 times earnings, the downside risk is probably quite limited. That said, the rally that was sparked in part by the turnaround in banking shares hasn’t been all that impressive: Volume has been somewhat light and the advance/decline data hasn’t been overwhelmingly bullish. That’s not the kind of action we would expect if we at the early stage of a major upward move.

Our guess as to how far the rally will run? If crude oil continues to correct—something we think is quite likely—stocks could stage a rally of between 5 to 10 percent before running out of steam.

Oil’s Slippery Slide

It’s kind of funny, as oil prices have gone from one new high to another speculators have been cited as the root cause for the gains. Yet on oil price pullbacks, supply/demand factors get the credit. Our take is that it’s a little of both.

Since peaking just a few short days ago above $147 a barrel, crude oil has plunged nearly $18 a barrel or 12 percent. It’s hard not to point a finger at speculators when we see that kind of action since the fundamental picture hasn’t changed markedly. But we don’t hear anyone cheering the speculators today.

To be sure, geopolitical tensions has eased somewhat with the U.S. State Department’s plans to establish an office (although not full diplomatic relations) in Tehran. That allows investors to breathe a little easier in the hopes that a peaceful solution will be found to Iran’s nuclear ambitions.

We’ve been thinking for some time the energy market is due for a much needed correction in an on-going bull market. We’re getting that now. Once that correction has run its near-term course, though, look for prices to start climbing again. The fundamentals in the U.S. aren’t all that bad. And China’s economy continues to expand at a better than 10 percent pace while global growth is running above 4 percent, suggesting that any slowdown in demand from Western economies will quickly be soaked up elsewhere.

Stocks have now fallen more than 20 percent from their high, which by all definitions qualifies as a bear market. Scary headlines and pictures of growling grizzlies, not surprisingly, adorn the covers of popular business and investment publications these days. But does that mean you should head for the hills? Hardly. In fact, the best buying opportunities occur when things look their worst. And right now things look pretty grim.

The stock market is just the start of a long list of woes. The credit crisis is a year old now and talk of government bailouts and financial institutions needing to raise capital is rife, housing prices continue to slump, economic growth is anemic, consumer confidence stands at a 16-year low, crude oil is trading north of $137 a barrel and geopolitical tensions are riding high, particularly in the volatile Middle East.

Given these conditions, we can’t rule out stocks falling further in the near term. But market sentiment usually gets things wrong at the extreme. And we’re seeing signs that suggest a decent sized rally could be near at hand. We touched on this last week, but we want to go into a bit more detail on the subject as it bears (pun intended) mentioning again.

Veteran stock market watchers know that you can learn a lot about where stocks are headed by looking beyond just the closing numbers on the major market averages. We put a great deal of emphasis at looking at what’s known as market breadth.

There are several ways to gauge this, one of our favorites is to examine the difference between advancing and decline issues on the New York Stock Exchange. Every stock market index has its quirks. The Dow Industrials, for instance, are price weighted, so higher price shares have a greater influence on the average. The S&P 500 is capitalization weighted, so price changes in larger stocks influence the benchmark far more than smaller ones. The Advance/Decline Line, however, which looks at all issues rather than a select few, treats all stocks equally.

So as to filter out possible day-to-day noise, we look at the composition of the A/D Line on a weekly basis. And right now it is generating an important message that far outweighs the fearful emotions that recent declines in share prices have likely engendered.

We won’t go into detail about how we compile our indicators, but suffice it to say that the market’s breadth has reached a negative extreme that has only occurred three times before in the last 30+ years. The last times the market was this oversold were in March 1980, October 1987 and August 1990.

As you can see from the table below, following each of those prior occasions the market went on to produce above-average gains in the following year.

	Extremely Oversold Markets
		S&P 500's Performance*
	Signal	3-months	6-months	9-months	12-months
	03/14/80	12.6%	22.0%	25.7%	29.4%
	10/30/87	2.1	3.8	8.0	10.6
	08/24/90	1.2	17.4	21.2	26.5
	07/03/08	?	?	?	?
	Average Anytime	2.3	4.7	7.3	10.0
	*Returns exclude dividends.

Of course there’s no guarantee that this time around we’ll get above-average stock market gains as we have in the past, but the market’s current bad breadth suggests that everyone who is going to sell probably already has. That paves the way for a proverbial “Wall of Worry” rally.

One likely catalyst for a rally would be a decline in oil prices. Crude prices appear to have run out of steam and in need of a correction. The oil bull market is far from over, but based on previous corrections, a pullback to the $120 a barrel area wouldn’t be a stretch. A retrenchment of that sized would likely be warmly received by investors.

Another possible spark to ignite a good leg up could be found in the employment situation. Jobless claims gave us a scare last week, climbing above 400,000. This week, the claims number was much more palatable, with a 58,000 plunge bringing the total to 340,000. The smoothed, four-week average also stands at a somewhat more easy to digest 385,000.

A sustained reading above 400,000 would be consistent with recessionary conditions. We’ll be watching this important leading indicator for signs that the economy is moving from a slow-growth period to outright contraction. But if claims remain around where they are today they, too, would be seen as a reason to move back into stocks.

America’s birthday is tomorrow, but few Americans are ready to celebrate. Beer sales this weekend are expected to reach their highest level for the year, but rather than raising a glass to our nation’s independence it seems more than a few people will be drowning their sorrows due to our dependence on Middle East oil.

Crude oil prices have topped $145 a barrel for the first time ever. And it’s starting to look like higher energy prices are starting to take there toll on the broad economy.

The Labor Department reported job losses of 62,000 in May, slightly more than expected. Moreover, another important employment market data point out today was that weekly initial claims for unemployment insurance rose to 404,000 in the latest reporting period. That brings the smoothed, four-week average for claims to their highest level since just after Hurricane Katrina. We’re watching this number closely as further increase could spell real trouble for the economy. And the upside of this data is that wag inflation is likely to remain in check.

Keep in mind that while the economy is struggling here, we still don’t have indications that we’re moving into a recession that will feed on itself in downward spiral fashion.

The financial sector may be mired in a recession, but other segments of the economy are doing okay these days. Take a look at the graph below. It maps out what’s been going on with manufacturers’ new orders for durable goods and an important subcomponent, new orders for non-defense capital goods, excluding aircraft.

The durable goods number is an index of the demand for goods designed to last at least three years, such as appliances, motor vehicles and airplanes. The survey measures current industrial activity and provides an indication of future business trends.

As you can see, the durable goods number isn’t setting the world on fire these days, as shipments of certain big ticket items such as autos have been weak. However, gains on things such as machinery, as well as fabricated and primary metals have kept the overall economy from sliding into recession.

Moreover, after dipping in late 2006, the manufacturers’ new orders for non-defense capital goods, excluding aircraft component has been trending higher. The trend in rising orders suggests that corporations are spending now for what should ultimately translate into future profit growth. And as our friends at the Bank Credit Analyst have pointed out, “stock market pullbacks during periods of rising durable goods orders are generally countertrend moves.” They go on to state “this year’s upward grind in core capital goods orders should not be ignored as an indication of ongoing non-financial sector profit resilience.” We couldn’t agree more.

Unloved and Oversold

Stocks have been in a downtrend since mid May. The Dow Industrials have declined more than 20 percent from their highs, and our favorite blue chip benchmark, the S&P 500, are hard on their heels.

There’s certainly a great deal of bad news out these days: The financial sector is in disarray with more losses expected, housing has yet to find a bottom, the consumers are tapped out and increasingly nervous about their jobs as well as rising prices for food and gasoline. Did we mention the threat of an Israeli attack on Iran dragging us into another conflict?

Given all of this we certainly can’t rule out stocks falling even further in the short run, especially with several technical levels on the major averages having been violated of late. Nevertheless, we want to remind you that stocks are forward looking and that all of the woes we discussed above are already priced into stocks.

We use several yardsticks to gauge whether stocks are overbought or oversold. This helps us to better spot significant turning points. By one proprietary measure we employ stocks have only been this over sold 10 times in the last 30 years. And while there’s nothing to say stocks can’t become even more oversold in the short run, we’re now that the point were it makes much more sense to be a stock buyer than a stock seller.

Looking at the last 30 years, the average 12-month gain on the S&P 500 following periods such as we find ourselves in now with stocks this oversold, has been a nearly 17 percent (excluding dividends). That’s far above the market’s historic annual gains. There’s no guarantee we’ll match that mark in the coming 12 months, but it’s nice to know the odds favor decent returns going forward.

Touché Trichet

Seeking to squelch inflation expectations, the European Central Bank (ECB) today raised its main lending rate for the first time in 13 months. The quarter of a percentage point hike brings the key rate to 4.25 percent. With consumer inflation to in the Euro zone running at 4 percent—double the ECB’s target rate of around 2 percent, further increases from the central bank can be expected in the months ahead provided the EU economy doesn’t slow significantly from where it stands now.

Weak data here in the U.S. means the Federal Reserve, our own central bank, isn’t likely to raise rates soon to match the EBC’s move. That means the dollar is likely to remain weak, adding to the inflationary pressures brought on by rising crude oil and food costs. So chances are this will remain a difficult investment environment, although we’re confident that good opportunities will crop up along the way.

The markets closed early today ahead of the three-day, 4^th of July weekend. From all of us here at the Leeb Group, we want to wish you a Happy and Safe Holiday!

Typically at this time of year, Wall Street is fairly quiet as many traders spend time away from their screens in favor of sunning themselves in The Hamptons. But that hasn’t been the case this week.

Stocks sold off sharply today, with the major averages down anywhere from 2.94 to 3.33 percent, depending on your chosen benchmark. The selling in the past month had been most heavily concentrated in financial shares. But today’s volume was extremely heavy and we saw more than 5 stocks shares falling for every one gaining and volume an even move lopsided at 9-to-1 to the downside, underscoring the broad-based nature of the selling. End-of-the-quarter window dressing added to the selling.

The television talking heads were all over the fact that the Dow Jones Industrials slipped to their lowest point since September, 2006. But the venerable index’s woes are largely a matter of problems with its handful of constituent members, most notable of which is the ailing General Motors which fell to a 53-year low today. But as we know, the days of “as goes GM, so goes the U.S.” are long over.

The broader-based Standard & Poor’s 500, while also down sharply today, has yet to take out its March lows. Moreover, certain key segments of the market are performing far better than the commonly watched Dow or SPX. The Transportation average, for instance, hit a record high just a few short weeks ago, and it remains well above its earlier lows. With oil closing in on $140 a barrel, the Transports strong relative showing is a very encouraging sign.

Another big divergence is taking place in the smaller stocks. Our favorite yardstick here is the unweighted average of all stocks traded on the NYSE, which treats all stocks equally rather than emphasizing size or price like other averages do. The unweighted NYSE average is good at capturing economic sensitivity. And right now their strong relative strength (they remain well above their lows) suggests that that this is not the start of a major bear market but is instead is just a correction.

If conditions deteriorate further we’ll certainly let you know. But for now, this isn’t the time to head for the hills, although caution should remain a watchword.

Saudis to World: Our Hands are Tied

Beyond Wall Street, the news is also typically low-key during the high season. But there have been a number of noteworthy stories to hit the wires this week that should set the tone for the market for at least the next several months.

On Sunday, leaders from around the world and executives of the major oil companies gathered in Jeddah, Saudi Arabia. Little came out of the summit, however.

Everybody’s favorite whipping boy, “speculators,” was trotted out as the excuse for today’s high energy prices. OPEC members insisted the market was “well supplied” with oil, all the while failing to point out that the oil they can’t find buyers for is high-sulfur content sour crude that’s difficult to refine. The Saudi king pledged to add 200,000 barrels a day to the market, but that’s just a drop in the bucket in the context of global consumption.

The reason the Saudis aren’t going to pump significantly more oil is because they simply can’t. We’ve seen a massive rise in the number of rigs drilling for oil in the desert kingdom in recent years, but the depletion of their aging fields has, at best, left them merely running in place. Everyone else in OPEC, sans strife-torn Iraq and Nigeria, are pumping flat out. For political reasons, Libya is even threatening to cut back on their production.

The blame game was also being played on Capitol Hill this week, with several Congressional hearings taking place to examine the role speculators are playing in the commodity market. From what we saw, Congress and many of the “experts” called to testify, are quite misinformed about how the market works.

As we’ve pointed out in the past, world demand continues to rise, even in the face of $140 a barrel oil. Yet production has remained flat since 2005, with output at several major oil exporters in decline and no big fields slated to come on steam anytime soon.

Another noteworthy news story this week was Dow Chemical Company’s announcement that it will raise prices by as much as 25 percent next month for a wide array of products. This follows a 20 percent price increase from Dow that went into effect June 1. With oil the main feedstock for many of Dow’s products, chances are good we’ll see even more price increases down the road. And we’ll move by Dow will by no means be an isolated incident: other companies are sure to follow suit.

So far, inflation has remained relatively tame. But unless the economy slides into a nasty recession—something we don’t see happening at this juncture—inflation is only going to get worse, possibly much worse.

FMOC to U.S.: Uh, Our Hands are Tied

The Federal Reserve’s Open Market Committee (FMOC) got together the other day, as they do eight times a year, to set monetary policy. As expected, the FMOC left short-term interest rates unchanged at 2 percent for the time being. In the accompanying statement, they let it be known that inflation was of greater concern than it has been in quite some time.

However, given the fragile state of the financial sector, Fed policy makers have no choice but to keep their policy on hold, no matter how much they’d like to raise rates. While some participants are betting that the Fed will start to hike rates this Fall, we suspect they’ll remain in neutral perhaps well into 2009.

Of course keeping rates low in the face of rising inflation, and credit tightening around the globe, will hurt the U.S. dollar. That, in turn, will exacerbate the inflation situation as it will mean we’ll all be paying even more for imported items.

This is a tough spot to be in and it certainly won’t make generating good money in the stock market easy. But we’ll remind you that investors in the right securities made a bundle in the inflation-torn 1970s. We plan to do the same this time around.

It has been a market of stocks rather than a stock market of late. Okay, so that phrase is a bit shopworn, but the tale of the tape shows the market has had somewhat of a split personality for much of the year.

Blue chips have struggled recently, surrendering much of their gains from the March lows. The more economically sensitive small caps, too, have retreated, but they rose much more off of their bottom and they’re much closer to their former highs. Of the two groups, the small caps have the better track record as a bellwether of what we can expect going forward.

Among the market’s various sectors, by far the worst performing have been financials. The broker/dealers had been headline grabbers, with Lehman Brothers stock tanking, even after the company was forced to return to the capital market to bolster their balance sheet.

Now the regional banks have been put under the microscope. And the feeling is we’ll see plenty more losses when the quarterly numbers come out. If so, that means there will be additional capital raising to follow.

Excluding the financials and the homebuilders (which themselves are really financials), however, the market’s action hasn’t been all that bad. Despite a doubling in oil prices in the past year, for instance, the transportation stocks are a mere 5 percent below record highs. Sure, the airline stocks are a mess, but the railroads, truckers and shippers are, by and large, doing well. The interest-sensitive utilities, meanwhile, appear to be pricing in more inflation, but not a contraction in the economy.

Don’t Take Our Word for It

We’ve been warning for some time now that inflation is steamrolling its way towards us. Short of a nasty recession that wrings out demand for a wide range of commodities, there’s little chance we’ll escape this ‘70s style price spiral. It won’t happen over night, but in the coming years it’s a safe bet we’ll all be paying a lot more for a wide range of goods and services, just ask any consumer.

The good folks down at the Bureau of Labor Statistics have long played down the inflation threat, going to far as to employ hedonistic accounting (saying something costs less this year than last—even though it doesn’t—because of so-called qualitative improvements). Ditto for the gnomes running the our central bank: They simply stopped reporting broad M3 money supply when it started to climb at a rate previous associated with banana republics.

Fed Chairs and Governors alike have also long emphasized “core” inflation, which excludes the effects of food and energy, because of the month-to-month volatility of these vital items. But judging from recent statements from current and former Fed officials, the current groupthink that says we should exclude food and energy from inflation calculations appears to be waning. The price shocks from these inputs can simply no longer be ignored.

The Producer Price Index (PPI) for finished goods rose 1.4 percent on a seasonally adjusted basis in May, raising the year-over-year gain to 7.2 percent. Much of the increase was related to…wait for it…food and energy. Moreover, increases in the cost of raw materials augurs for further acceleration in the PPI ahead.

Consumer prices, meanwhile, have remained more contained as producers have been reluctant to pass the higher costs on at the retail level. They can only do that so long, however, before it takes a real bite out of profits.

As consumers open their wallets at the grocery checkout or after topping off their tank at the pump, they’re under no delusion that that food and energy don’t matter. And as the graph below shows, consumers’ expectations for inflation are on the rise.

The graph maps out the CPI and consumer’s year-ahead expectations for inflation, as reported in the University of Michigan’s monthly survey. At 5.1 percent, sentiment stands at its highest level since the early ‘80s. We’ve shifted the consumers’ expectation ahead one year to see how it stacks up with prevailing inflation. As you can see, consumers’ inflation expectations generally aren’t all that far off the mark over time.

Rather than using sophisticated statistical models to make their predictions, people simply base their year-ahead predictions on the recent past. As a result, consumers tend to consistently lowball inflation in periods when inflation is accelerating and they regularly tend to overestimate inflation when it’s decelerating. This is a classic case of viewing the road ahead through the rearview mirror.

With inflation clearly expanding right now, chances are good that consumers are once again underestimating the level of inflation they’ll be faced with in the coming year.

Another factor to consider is that unlike in the 1970s, the bout of inflation we’re experiencing today has come about in the absence of wage inflation.

Private sector workers’ average hourly earnings increased only 3.5 percent in the 12 months ended in May. And that figure was a half percentage point less than in the prior year. But with general price expectations accelerating, it’s likely that workers will start to demand higher pay to compensate for the increase in the cost of living. That, in turn, will feed on inflation, making the situation even worse.

Today’s $5 decline in the price of oil is a welcomed sight. Thank you China! But it will take a lot more than that to tame inflation—something we just don’t envision happening anytime soon.

Higher inflation is by no means the end of the world. It will, however, keep stock prices in check, making careful stock selection all the more important in the coming years.

Eight times a year the Federal Reserve releases an assessment of economic conditions in its 12 Regional Bank territories. Yesterday we were treated to the latest of these reviews in its Beige Book, so called for the color of its cover.

The view from the central bank is that the U.S. economy remained generally weak last month and that higher energy and commodity prices are being passed on to consumers in some areas. The Fed reported that the economy was stable in five regions but described conditions as weak or soft in the other seven regions.

No real surprise there, but we’re encouraged that the Fed sees conditions aren’t deteriorating as you might infer from some recent economic reports. Take, for instance, last week’s big jump in the civilian unemployment rate, which sent shutters through the stock market.

We would caution against reading too much into the headline 0.5 rise in the unemployment rate. Typically such big increases occur within the context on-going recessions. However, there have been a number of cases in which such increases occurred when the economy had merely slowed rather than in a contraction. More importantly, a half a percentage point increase in unemployment has little or no bearing on what stocks did in the subsequent 12 months.

In the past 60 years, 85 percent of the time following a 0.3 percent monthly increase in the unemployment rate, stocks have risen in the following 12 months, on average by 15.8 percent (excluding dividends). Factor in the yield and you would have done even better remaining invested. That doesn’t guarantee a good showing by stocks this time around, but it’s worth pointing out.

In a worst-case scenario, blue chip stocks could very well struggle for an extended period of time if inflation picks up, as we expect. However, the relative performance of small caps has been such that the chance of a bear market in the little guys is quite remote. Of course there are pockets of weakness that bear close scrutiny. Most notable of these is the financial sector.

The credit crisis, which has been going on for more than a year now, continues to take its toll on once rock-solid companies. Just a few days ago Lehman Brothers raised $6 billion to shore up its capital position. While the company found willing buyers for its common and preferred stock, Wall Street remains unconvinced Lehman has turned the corner. In just a few short days, the stock has declined by another 30 percent, raising the specter that it will have to be bailed out by another firm. In the process, Lehman has taken the rest of the financial sector, and indeed, the entire market down with it.

Until we get stability in the financial sector stocks, overall aren’t likely to make much in the way of forward progress.

When All Else Fails, Jawbone

Always the bride’s maid, never the bride. That seems to be the story with the bond market. Try as it might, it never seems to capture the public’s attention the way the stock market does—despite the fact that the dollar volume in bond trading is far larger than the equities market.

We can’t say precisely where they’re headed, but we can say that bonds bear watching here. Bond yields have been trending higher since March, signaling that strong growth and/or higher inflation is coming down the pike. In just the last few weeks, traders’ expectations for the Federal Reserve to raise short-term interest rates have gone from a slim possibility to a consensus that we’ll get a rate hike by September.

This shift is due in part to comments from various Fed officials about their concern for inflation. Frankly, we think the Fed will stand pat for a while (assuming the economy doesn’t slow down). Instead, members of the central bank are merely jawboning to keep inflation expectations in check.

Managing expectations is important because if consumers believe more inflation is in the works, they’ll begin to act accordingly—which itself can serve to add fuel to the inflation fire. Considering that University of Michigan’s consumer inflation expectations index recently rose to its highest level since 1990, the Fed has cause for concern.

A symbolic rate hike of just 25 basis points would have no impact on the inflation picture. Instead, it would require a series of increases to do the job. But the central bank’s hands are tied in that it doesn’t actually want to raise rates for fear of hampering the economy.

The moral suasion these days isn’t just limited to the topic of interest rates, either. We’re also hearing talk from the White House, the Treasury Department, and from high-ranking Fed officials regarding the ailing U.S. dollar. But here, too, just saying you’re for a “strong dollar” won’t make it so.

The dollar’s course in the short run is likely to be a divergent one. It’s likely to appreciate against the Euro, but it’s likely to continue to lose ground against the currencies of rapidly expanding emerging economies such as the Chinese yuan and the Brazilian real. Longer term, the greenback will remain in hot water unless we get our financial house in order, something we don’t see happening anytime soon.

It goes without saying that a weak dollar is inflationary, since it means we have to pay more for imported items running the gamut from raw materials to finished goods.

Lies, Dam Lies and BP’s Statistics

Yesterday, energy giant BP released its annual Statistical Review of World Energy, a global survey of energy production and consumption on a country-by-county basis. The startling takeaway from the eagerly anticipated report is that despite the strong run up in crude oil prices in the past few years and a 1.1 percent increase in global oil demand, we actually experienced a decline in oil production in 2007.

The traditional economic model that says higher prices for a certain item will lead to increased production of that item clearly isn’t working this time around. Our long-held fear that the world is rushing headlong into an energy crisis is underscored by the BP report.

Saudi Arabia, which accounts for nearly 13 percent of the world’s crude and is the largest oil exporter, is the key. For some time now they have been seen as the swing producer; able to increase their output to meet demand if need be. The bulk of their production, however, comes from the massive but aging Ghawar oil field. Given Ghawar’s size, once the flow rate from that single field peaks, the world’s annual oil production rate will have also peaked.

The Saudis contend that Ghawar is in no danger of peaking. Yet their activity in recent years says otherwise. They’ve been punching new holes in the ground like mad in search of oil, but they have repeatedly come up short of their production forecasts.

To give you an idea of how dire the situation is you need look no further than the dramatic declines in flow rates from other countries that have passed peak production. As discussed in BP’s report, Mexico (which openly admits that its primary field is past peak), has seen its output decline by nine percent in the last two years. In the last six years, Norway’s annual oil production has plunged 25 percent. And the United Kingdom’s output is down an astounding 43 percent in the last seven years.

So with the Saudi’s output down more than six percent in the last two years despite their frantic efforts to find new oil, it’s safe to say the days of cheap energy are behind us. Incidentally, in terms of oil exploration, the U.S. is the most picked over country in the world, accounting for more than half of all oil wells ever drilled, yet our crude production has been falling steadily since the early 1970s.

The Saudis have set up a summit between energy producers and consumers for June 22. OPEC has no plans to increase production, though—not that they can in any meaningful way. The head of the International Energy Agency (IEA), meanwhile, has declared that the world faces an oil crisis due to growing demand. Scary stuff.

Your Tax Dollars at Work

With crude oil prices approaching $140 a barrel, the national average for gasoline above $4 a gallon and numerous industries suffering from soaring fuel costs, you would think our elected leaders in Washington would be in a hurry to do what that can to alleviate the situation by setting a sensible energy policy. But then again we’re talking about politicians here.

Yesterday, the Senate, in its infinite wisdom, decided not to extend the renewable energy and energy efficiency tax credits in House bill H.R. 6049. These credits are set to expire at the end of this year. There’s still hope that the credits will be extended via an attachment to another bill, but we’ll just have to wait and see if Congress takes action.

Stocks sprung back on some good news from the economic front – better than expected employment figures coupled with some signs of consumer resilience have caused the market participants to come back in strides. The Labor Department reported today that applications for unemployment benefits totaled 357,000 last week, some 18,000 fewer than the previous week, reaching the lowest level since mid-April. This news, coupled with the higher-than-expected May sales that were reported by some retailers, gave Wall Street a much needed boost. While the retailers that have reported better sales gains are the ones who discount the most (WalMart and Costco), the job data does support that consumers are stronger than expected and that the U.S. consumer will likely keep spending as long as he or she is employed.

The better-than-expected initial jobless claims report came on the heels of yesterday’s positive news on the job creation front. ADP reported yesterday that U.S. companies added 40,000 jobs in May, as compared with 13,000 job increases in April and the expected decrease.

Yesterday, the Fed Chairman Ben Bernanke commented on the economy, saying that he does not feel that the U.S. will experience the same out-of-control prices seen with the oil shocks of the 1970’s. While the official inflation number (over the past four quarters, the inflation rate has averaged about 3.5%) is still significantly higher than the Fed would ideally like to see, it is less than the double-digit rates of inflation in mid-1970s and 1980s. This may have also helped to calm down the markets.

On the other side on the pond, Jean- Claude Trichet, President of European Central Bank (ECB), has announced that policy makers may in fact slightly raise interest rates next month in order to contend with the increasingly worrisome inflation risk.

Oil bounced back with vengeance today, breaking its recent downtrend. We’ve said before that we would be more than happy to see crude prices drop back toward $100 a barrel, but we would not expect them to stay there. Here’s another reason why.

In a story this morning, Bloomberg.com gave more details on the recent Petrobras’ oil find off the coast of Brazil. Although it is still too early to estimate exact costs, the report stated that Brazil's recent oil discoveries may end up costing more to develop than previously expected. Of course, the fields could be huge -- they may in fact hold as much as 50 billion barrels of crude and $6 trillion worth of petroleum, making Brazil one of the ten largest oil producers in the world. However, extracting from these fields is no cake-walk. Enormous costs and logistical difficulties mean Brazilian oil company Petrobras will need the help and expertise of the world’s most experienced producers, such as Exxon, in order to finance the equipment needed to reach the trapped crude.

Petrobras plans to hire at least 14,000 engineers, geologists, and drillers within the next few years in order to take on this daunting task. Altogether, it may take 20 years to develop the field. And the costs, you’d ask? This all could cost a record-shattering $240 billion, equivalent to the budget of the U.S. space program for the next 14 years!

The high price of oil has started to cut into the lifestyle of the U.S. consumers and into the behavior of the manufacturers. For instance, General Motor’s CEO Rick Wagoner said that “The unprecedented rise in oil prices... which have more than doubled over the past 12 months alone... is having a significant effect on U.S. auto industry sales levels, and especially sales mix, as consumer demand shifts from trucks and SUVs, to cars and crossovers,” before G.M.’s annual meeting. Moreover, The New York Times quotes Wagoner as saying that “We don’t believe it’s a spike or a temporary shift. We believe it is permanent.” Ford and GM sales plummeted in May, as the fuel-loving SUVs and pickups, which make up a serious portion of their respective product lines, are hardly moving off lots. In response, on Tuesday GM announced drastic cuts in production of sport utility vehicles and pickups, and stepped up plans for smaller cars and engines, and is also ordering a strategic overview of the Hummer Brand. The company is essentially throwing in the towel on the struggling line of large SUV’s. GM will be considering all options for its Hummer line, from revamping it to a complete sale of the brand.

Of course, it is easy to guess what sorts of automobiles will sell better in times of $4 gas. Overall, GM sales are down 28% from one year ago; Ford is not far behind with sales down 16%. In the not-so-surprising-news category, Honda Motor Co.’s Civic beat out Ford’s F-series pickup for the best-selling vehicle in the U.S.

The rising oil prices are affecting airlines as well. United Airlines announced that it will be grounding 70 planes and cutting as many as 1,100 jobs, and Continental Airlines has announced that it will be eliminating 3,000 jobs and decreasing its fleet by 67 planes. Continental makes the fourth major U.S. carrier to cut its payroll and plane numbers due to increasing fuel costs, shedding further light on the airline industry’s ever worsening crisis. Analysts at JPMorgan have estimated a $7.2 billion loss for the entire airline industry for 2008.

To conclude: stay invested, but don’t forget about having some energy stocks in your portfolio. You’ll need them.

Crude oil prices topped $134 a barrel this morning. As you know, we’ve long anticipated sharply rising oil prices. But we’d be lying if we told you we weren’t a little nervous with what we’re witnessing these days.

We’re now well above the sort of price increases which typically lead to economic contractions. Moreover, even the oil producers—the very companies that will benefit from higher prices—are starting to struggle. If we see these shares start to sell off even as oil prices advance further it would be a proverbial fallen canary in coal mine signaling trouble ahead for the overall economy and stock market.

Yesterday, Congressional leaders hauled representatives from some of the nation’s largest oil companies up to Capitol Hill for questioning. The senators were demanding an explanation as to why gasoline prices were so high right now. Judging by their remarks, members on both sides of the aisle demonstrated that they have little or no understanding of how the oil business works.

Despite a more than doubling in crude prices in the past year, gas prices have risen less than 20 percent on average, thanks to refiners taking a massive hit to their margins. But Big Oil is an easy target when looking for a scapegoat.

The oil execs, clearly fearful of the imposition of a windfall profits tax, offered numerous—and frequently misleading—excuses as to why crude oil prices have risen so dramatically. Unfortunately, none of the guests had the courage to look the senators in the eye and tell them that if they thought oil prices were high now they’re in for a rude awakening.

What passes for an energy policy in this country is a joke. Last week President Bush went hat in hand to the Saudis to plead for more oil. In response, the Saudis offered nothing more than a token gesture—which will have absolutely no impact on the price of a barrel of crude.

For its part, Congress has yet to push for conservation measures or the serious development of alternative energy sources. Our legislative branch’s biggest accomplishment has been to put a halt to stockpiling the Strategic Petroleum Reserve (SPR). But stopping the trickle of oil flowing into the SPR will not bring down prices.

Congressional leaders are also threatening to sue OPEC for not selling us all of the oil we want. With Congress stocked mostly with lawyers you would think they’d understand that they don’t have a leg to stand on when it comes to forcing OPEC’s hand.

We do expect oil prices to correct at some point given the move they’ve had. Our fear, though, is that the correction will occur because the economy is in real trouble. But for now, the overwhelming weight of data continues to point toward tepid growth, not recession.

The Fed’s Next Act

The specter of stagflation has appeared again, this time it was sighted in the marble halls of the Federal Reserve’s headquarters on Constitution Avenue—or more specifically in the pages of the central bank’s meeting notes.

Yesterday we got a peak at the minutes from the Fed’s last Open Market Committee meeting at the end of April. In it, we saw that the central bankers are increasingly worried about both inflation and slow growth. The policy makers lowered their expectations for growth this year while raising their estimates for consumer inflation.

The Fed reduced its 2008 anticipated gross domestic product (GDP) reading to between 0.3 percent and 1.2 percent. That’s down from a forecast for growth of between 1.3 and 2 percent. Given the rut the economy appears to be in won’t quibble with that forecast, although we are somewhat hopeful the housing sector will start to revive by year’s end, possible adding to the expansion.

Bernanke and Company are now projecting that core consumer inflation with run at an annual rate of between 3.1 and 3.4 percent in 2008, well above last year’s pace. They’re optimistic that inflationary pressures will subside in 2009, however, due to businesses having difficulties passing on prices to consumers. Our work, however, suggests that the Fed will have to reconsider its inflation expectation s with an upward bias with passage of time.

The comments leave no doubt that, barring some unforeseen event; the central bank will not be easing credit further anytime soon. Of course with only slow growth on tap, Bernanke will be loath to raise interest rates either, despite mounting inflationary pressures.

That means stocks are likely to remain mired in a trading range for some time to come. As a result, dividends are destined to play a big role in stock returns in the year ahead.