What a Difference 18 Months Make (or, Reality Bites)

JD, a long time Big Picture reader (and GP of the Gryphon Fund) writes in:
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When reality is shockingly unpleasant, the market sometimes chooses to ignore it. Eventually, though, reality cannot be denied.

Start with the housing downturn, whose significance many underestimated (including the Fed). Then there was the sub-prime situation, which many people (once again, including the Fed also) erroneously believed was contained. As Jim Grant wryly observed, it was "Contained" — to Planet Earth.

Add to this the hard- and soft-commodity inflation emerged which many — including the Fed — thought was anchored.

I’m starting to notice a pattern here . . .

All this denial led to the biggest credit crisis in 50 years with risk being reassessed as credit spreads widen and remain wide.

Nothing really to worry about, said the pollyannas. As long as people were employed, we would be okay. That notion just went out the window as the Financials took major losses last quarter, are likely to take more losses this quarter, and have been aggressively cutting jobs. So far, we’ve had 3 negative jobs reports since September 2007.

The Fed has complicated the current situation: In both September and January, the FOMC aggressively cut rates, in both instances, much more than expected. A measured response from the Fed would have been appropriate; however, their panicky monetary policy will ultimately backfire. This was a credit problem -  not an interest rate problem.

The bigger issue is the Fed signaled to speculators in the commodities and currency markets that the they were throwning in the towel on inflation, and were prepared to print money until we run out of ink. Its no coincidence that Commodities then exploded upwards – the biggest monthly moves since the 1970′s – along with the dollar tanking, and gold rallying 40% since August 2007.

This put even more pressure on struggling consumers as prices lifted on almost everything sold at the supermarket.

Since July 2007, market leadership has gotten increasingly narrow, while internals are horrific. In July  2007, money flowed out of financials and into technology and commodities. Our internal expectations have been for the technology rise to reverse itself and return to Earth as firms cut IT spending, and consumers allocate scarce resources to essentials only. We see this starting to play out now.

NASDAQ has gotten crushed since November, as the hot money has fled. The final leadership group in the market is commodities — either physical commodities or commodity stocks. If this is, indeed, the deep recession and bear market I believe it is, commodities will be hit next for, in the end, they throw the baby out with the bath water AND the piano AND the piano player for good measure. (Editor: My apologies for the mixed metaphors!)

Last week, we heard the people who previously were saying there will be no recession (or only a mild recession) begin to experience what Barry has been calling cognitive dissonance. As their portfolios have suffered, they came to understand that reality will not be denied. Reluctantly, some have begun to remove the rose-colored glasses they have worn for the last several years.

While I believe we’ll probably bounce here for several reasons, I also believe all rallies will fail and the final leg down will come when the only leadership group left — commodities — fails.

Over the next two weeks, we will get quarterly earnings reports from the brokers. That could produce a relief rally — or at least an oversold bounce — simply based on how badly they have been crushed recently. Further, we also have the March 18th FOMC meeting a week away. Let’s see if they make another mistake by again cutting too aggressively, thus making speculators happy for the third time — and prolonging this recession.

International companies probably benefited from the recent dollar swoon, so some reports may mask weakness with currency gains, but as Jim Rogers (a dollar bear AND right) has said recently, the dollar could be in for a sharp rally. As the U.S. falls deeper into recession, other countries economies will feel the pain and they will be forced to start easing to help the dollar. The global economic slowdown is prolonged each day that Europe (and the rest of the world) does not cut rates to tame inflation caused by a reckless U.S. Fed. 

–JD

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Thanks, JD — appreciate the overview . . . 

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