The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Jim Welsh of Welsh Money Management has been publishing his monthly investment letter, “The Financial Commentator”, since 1985. His analysis focuses on Federal Reserve monetary policy, and how policy affects the economy and the financial markets.

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In the October and November letter I wrote, “My guess is that the DJIA will drop below 7,882, but hold above 7,200 in coming weeks. If this develops, a one to three month rally could follow, as analysts convince themselves that a narrowing in credit spreads and a second bigger stimulus plan will mean the economy will begin to recover by mid 2009. As more investors embrace this scenario, selling pressure will dry up, and coupled with a little buying and some short covering, the market will rally on lighter volume. This is what happened after the March low, and the market rallied for two months. If this plays out, the DJIA could rise to 9,600-10,200, and the S&P to 1000-1050. My guess is that after this rally is over, the DJIA will likely drop below 7,200 by next spring.” In the November letter, I wrote, “So far this scenario seems on track. However, the DJIA has really been masking the weakness in the overall market. The S&P is below its October intra day low by -4.0%, the Russell 2000 and Nasdaq 100 are both below their October 10 lows by -11.7%, even as the DJIA holds above 7,882. This degree of weakness increases the odds that the 2002 and 2003 lows will be tested sooner, rather than later. If the DJIA drops below 7,882, traders should look for an entry. Needless to say, with the VIX above 70, this is not for the faint of heart. Where ever you choose to go long, use DJIA 7,200 as a stop, and raise the stop to the DJIA low, if the DJIA climbs above 8,200.”

At the low last Friday, the S&P was -11.9% below the intra day low on October 10, while the Russell 2000 was -20.7% below its low. I’ve heard some analysts call this a successful retest of the October 10 lows. Given how far these averages fell below their prior lows, it seems more like a breach to me.

I wish some of my teachers in school had considered a 62 a successful test of my math skills.
About an hour before the close on Friday November 21, it was leaked that Tim Geithner would be
the new Treasury Secretary. By the end of the day, the DJIA was up 500 points. Justified? Not really.

After all, Geithner has been Paulsen’s right hand man all during this crisis, and has been very
involved in all the decisions made along the way. So, Geithner is not going to bring any new
perspective to the table.

But on Tuesday November 25, the Federal Reserve and Treasury announced plans to support the
securitization markets for credit cards, auto loans, student loans, and mortgage backed securities.
This is good. As I have noted over the last year, securitization has become an integral part of the

credit creation process over the last 15 years. This meant the Fed had less control over the amount of credit flowing into the economy leading up to this crisis. More importantly, it meant the Fed would have less leverage in containing the crisis as it continued to develop. Over the last year, the securitized volume of mortgage debt, auto loans, and credit card debt has declined by more than 75%. The breakdown in securitization of lending has led to less availability of credit for even credit worthy borrowers. The steps announced on Tuesday should help.

President-elect Obama has also indicated that he will propose a very large stimulus package to support the economy. It has been my expectation that the prospect of a bigger stimulus program would result in a growing number of investors to expect the economy to do better by mid 2009. This would lead to a drop in selling pressure, which meant a little buying and short covering would be able to lift the market. My guess is that this rally began last Friday. This rally that will be very choppy, as negative news will continue to buffet the equity market. A rising wedge pattern sounds possible. Time wise, this rally should approximate the length of the March-May rally, 9 weeks, give or take a little.

Fundamentally, it will occur as people hope that a bigger stimulus plan will turn the economy around. Instead of $150 billion, like this spring, President-elect Obama will announce a far larger stimulus plan, maybe $400-$500 billion, or 3% of GDP. Most people will confuse an artificial boost to GDP as evidence of a self sustaining recovery. There is a big difference, as I noted in the February and March letters. In the spring, most analysts expected the $150 billion stimulus plan would lift the economy in the second half of 2008. I really didn’t think it would, since a one-time stimulus plan boosts GDP, only as it passes through the economy. Once the money is spent, used to pay down debt, or saved, the support for the economy wanes. Although it succeeded in boosting GDP in the second quarter, it failed to launch a self sustaining economic expansion. A self sustaining expansion needs no artificial stimulus to maintain itself, as confidence is high enough that consumers spend their own money and companies hire and boost capital expenditures. It is possible, of course, that a big enough stimulus plan could provide enough forward momentum to launch a self sustaining recovery.

That’s everyone’s hope. However, unless credit creation is revived sufficiently by banks and within the credit market, the economy won’t have the available credit it needs to sustain the forward momentum provided by the stimulus. Given the structural breakdown in the credit creation process within the banking system and credit market, and the contraction in economic activity we’re seeing in the fourth quarter and in next year’s first quarter, the economy will likely slow, after getting a lift from the stimulus plan. Will that post stimulus plan slowdown be deep, or a dip, before the economy begins growing? My guess is that it will be deep enough to cause the stock market to drop below last week’s lows.

In the meantime, the market should be able to hold up for 6 to 10 weeks, maybe a bit longer. Traders were advised to pick a spot to go long, once the DJIA dropped below 7,882, using 7,200, the 2002 low as a stop. The actual low last Friday was 7,450. I would raise the stop from 7,200 to 7,700. If the DJIA gets above 9,000, raise the stop to 8,050. Sell half if the DJIA reaches 9,540. For those who missed the reversal, buy if the DJIA falls below 8,300, using 7,950 as a stop. Sell half if the DJIA reaches 9,540

-E. James Welsh