Orders for durable goods in the US declined 6.2% last month, the biggest monthly decline in two years.  Additionally, consumer spending declined 1%, in spite of a modest increase in personal income.  Revised US GDP in the 3^rd quarter was down .5%, the worst decline in seven years.  Consumer spending has had the sharpest drop since 1980. 

Internationally, Euro zone unemployment hit 7.7% in October, the  highest since January, 2007.  Industrial production in Japan fell 3.1% in October, more than expected.  The World’s # 2 economy has contracted in industrial production for the first 3 quarters of 2008, and forecasts of Q4 industrial production is down 8.6%.  Forecasts are for a severe recession in Japan. 

As for companies, the Big Three automakers are returning to Washington DC requesting $25 billion to provide cash to operate in 2009, without which, all would run out of money and face bankruptcy.  Congress is requesting a plan to return to profitability, that also provides payment of its long-standing pension obligations, that increases fuel efficiency, and limits executive pay.  Citibank rose 120% last week, from the government’s $20 billion injection into the bank, and the guarantee that the government will bear losses above $29 billion on the bank’s $306 billion of poor quality, loss-producing assets. 

Markets

The 10 year Treasury note now yields 2.92%, a 50 year low, down from 3.79% two weeks ago.  It represents a flight to quality, and current Federal Reserve policy to provide liquidity and lower money rates. 

Most equity market indexes rose for the week, as this week was one of the best for investors in all of 2008.  The short week made for light volume, especially on Friday, when most people were enjoying the Thanksgiving holiday.  For the week, the NYSE Composite rose 12.9%, the S & P 500 rose 12%, the NASDAQ Composite rose 10.9%, and the DJIA increased 9.7%, despite bad economic reports. 

As of Friday, November 28, 2008, the S & P 500 was down 39%, while the NASDAQ Composite was down 42.1%, and the DJIA is down 33.44%.  Internationally, the Morgan Stanley developed markets index is down 45.7% in USD terms, while the emerging markets index is down 59.8% in USD terms. 

Impact of the current recession

Many technology companies, such as Dell, Cisco, & HP all plan to extend furloughs over Christmas, to reduce hours and costs.  Companies are attempting to first reduce hours, before cutting jobs.  It is likely that if the recession continues, these companies will cut jobs.  The state of California plans to do the same, as do the three US automakers and Toyota. 

Russia is having a difficult time these days economically.  They have spent $148 billion to defend their currency, the rouble.  It is likely Russia will have to devalue the rouble to avoid losing their remaining $325 billion in currency reserves.  At present, Russia is cutting oil & gas projects. 

Federal Reserve Policy

The Federal Reserves mantra these days is to do “whatever it takes”.  The Federal Reserve did some novel things last week.  First, it created a $200 billion facility to buy asset backed securities, including mortgages.  This will be used to buy newly issued asset backed securities, such as credit card loans, mortgages, student loans, auto loans, etc., which will supply new credit to American consumers.  This is very significant.  It means that the Federal Reserve for the first time will be a direct lender to consumers.  Going forward, many homeowners will be sending their payments to the Federal Reserve.  And the program will also include other consumer lending, to supply credit to consumers.  This new facility was created because banks, in spite of capital injections by the US Treasury, are not lending. 

Secondly, the Federal Reserve promised to buy $500 billion of mortgage backed securities from Fannie Mae & Freddie Mac, two government sponsored enterprises, which have issued $6 trillion worth of securities.  The current Trouble Asset Rescue Plan (TARP) created by the Treasury was created to buy bad mortgage assets, which had wiped out bank capital, and was meant to provide liquidity to the banks.  Since US financial institutions needed capital, that is the primary use so far of the TARP funds.  All but $20 billion of the first $350 billion has been committed.  Still, there is the need to buy these assets, so the Federal Reserve will do this also. 

Thirdly, the Federal Reserve committed to buying $100 billion of Fannie Mae & Freddie Mac’s direct debt.  So the Federal Reserve will be recapitalizing these two government sponsored enterprises.  Together, they hold $6 trillion of securities, which if they were combined as commercial banks, would be larger than the current three largest US banks, Citibank, Bank of America, and JP Morgan.

The Federal Reserve will be funding these new $800 billion programs with newly created reserves; which means, that they will print money.  This allows leverage to work.  Since the Federal Reserve is acting as a bank, it will only need $80 billion in capital to fund the $800 billion in new obligations.  Leverage was the culprit behind most financial institution failures, and now the government is using leverage to pull us out of financial crisis. 

I am concerned about the obligations they Federal Reserve is taking on.  The Federal Reserve has expanded its balance sheet in 2008 from $900 billion to $2.2 trillion in August, to $3 trillion, with the new programs.  Still, the Treasury needs to issue bonds to pay for the TARP program, at least $350 billion, and in future, the Federal Reserve will have to pay its new obligations.  Meaning, bond issues will be huge, potentially $1 trillion or more.  The US government and the European governments are now dominating capital markets. 

Also, money market rates have withered to nothing and long bond rates, like the 10 year Treasury are down 1% or more.  Inflation for 2009 will be negative.  But inflation beyond 2010 will be horrific.  Every time the Federal Reserve lowers Fed Funds below the rate of inflation, they increase inflation in the future.  And all of the new lending by the Federal Reserve is inflationary.  For bond investors, it means they have increased credit risk due to deteriorating cash flows at most companies, and that long bond rates will likely increase, causing losses for new bond investments.  I also believe that long-term holders of bonds are not being compensated for inflation. 

Conclusion

I am buying large-cap, US companies that have become good values from the overall decline in the US equity markets, along with growth companies that have suffered P/E compression of 50% or more.  I am holding a lot of cash, as I am less interested in bond markets due to credit risk, interest rate risk, and inflation risks.   As for bonds, I am only buying short, 1-5 year Treasuries. 

Once Europe & Asian central banks are done cutting rates, I expect the USD to fall, and then it will be time to buy commodities again.  I am selectively buying oil companies. I expect commodities to reflect real inflation, thus commodities such as oil, gold, silver, & grains should increase significantly in the near future.  Commodities & equities will be needed to fight inflation, and preserve the value of your portfolio. 

We have not bottomed yet.  I believe that we will retest the old S & P 500 low of 752 set 10 days ago.  Financials, technology, & consumer discretionary stocks are very weak, so it is unlikely we are starting a bull market anytime soon.