Good Evening: While the news flow affecting our capital markets has remained unswervingly negative over the past few days, the U.S. stock market has managed to hold up relatively well. Rather than ascribing this recent resiliency to an increase in the number of values on offer, it is perhaps possible that investors are hoping the Fed’s two day meeting somehow yields a pleasant surprise. If so, then the U.S. dollar (and later, Treasurys?) may switch positions in the performance tables with commodities in 2009.

As last week limped to a close, jobless claims soared, retail sales dove, and the automakers stood just outside of bankruptcy court. Pushing Rick Wagoner off the front page, Bernard Madoff then managed to slip past the Big 3 and register a rare double: he appeared in criminal court while his previously large investment fund became the subject of a bankruptcy proceeding (see below). Mr. Madoff’s confessed behavior put an exclamation point on a week that might be described as fitting only for a Hall of Shame. Along with earlier candidates, Rod Blagojevich, Marc Dreier, Franklin Raines, and Richard Syron, Mr. Madoff is now eligible for the Gulag treatment I mentioned last week. And yet, in spite of all this negativity, stocks closed the week on an up note. Many market veterans could only shake their head in wonder.

Heading into today, U.S. stock index futures were pointing higher in the wake of positive action overnight in overseas bourses. After opening mixed to a bit higher, the major averages headed south as they digested the latest batch of poor economic news (see below). The Empire manufacturing survey remained in decidedly negative territory, industrial production and capacity utilization both tailed off last month, the housing market index stayed in record low territory, and the Treasury International Capital (TIC) report revealed that foreign appetites for long term U.S. assets dropped to a mere $1 billion in October (see Merrill’s take below). One month’s data are not a trend, but the TIC announcement did seem to add unwanted pressure to our currency today. These figures will bear watching in the months ahead as we try to finance our burgeoning budget deficit.

The major averages continued to back off until they were down between 2% and 5% with an hour to go in the trading session. A late rally clawed back approximately half those losses, leaving the averages down between 0.75% (Dow) and 3.4% (Russell 2000). We’ve seen more than a few of these final hour rallies lately, and many have come ever since the Fed announced this week’s FOMC meeting would be extended to two days instead of the previously scheduled singleton. Analysts and strategists have been all over the map in guessing what this schedule change means, but I doubt the Fed would add a second day in this environment unless they wanted to shift policy in some way. Market participants expect another cut in the fed funds rate, but my gut tells me they will announce a shift away from targeting interest rates for the time being in favor of targeting the level of bank reserves in the system. Such a move would be called “Quantitative Easing” by the pundits, and a “buy signal” by those who still haunt the commodities pits. That the dollar has recently become weak in the knees while gold and other commodities have shown signs of life might not be just a coincidence. Today the dollar was down 2%, gold was up a like amount, and weaker energy prices caused the CRB index to close on the shady side of unchanged.

The stock market, especially one openly worried about deflation, might also welcome a further opening of the monetary spigots. A generation of analysts and Fed-watchers have been weaned on nothing but interest rate targeting as the Fed’s primary instrument of monetary policy. If the Fed shifts its focus from the price of money to the volume of bank reserves, then the door will be open for Quantitative Easing. Pre-Greenspan era monetarists will recall that a similar approach was undertaken by Paul Volcker in October of 1979. Unlike Volcker’s desire to restrain reserve growth, however, the Bank of Bernanke is likely to want to encourage growth — even wanton growth — in bank reserves. Whether such a move will be announced tomorrow (or ever) is an open question. In fact, if the FOMC simply chops the fund rate by 50 bps and puts out the standard press release, then the markets could be in for a rough ride tomorrow. But should the Fed take steps toward Quantitative Easing, especially as the markets head into the less liquid periods around year end, then the shorts might find themselves in a tight spot. With Mr. Market weighing these policy possibilities, maybe it’s not so strange that the mining stocks are feeling a tailwind for the first time in months.

– Jack McHugh

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