Don't Count on the Fed to Save Stocks in 2008

The Dow and most foreign stock-markets enjoyed a blistering rally on Wednesday but heading into this morning’s trade the futures look pretty ugly. Earnings from Merrill, Lynch, Motorola and Pfizer all point to poor results and the markets are heading lower in the United States and Europe. No surprise for this bear…

Stocks can still muster a significant bear-market rally. The S&P 500 Index and the MSCI World Index have logged almost six consecutive monthly losses; in previous bear markets, including the 2000 to 2002 period, equities did manage to post some big rallies. Of course, these intermediate or short-term advances were just opportunities to sell stocks as markets eventually broke down to newer lows.

What’s amazing about the last bear market is that stocks continued to plunge even as the Federal Reserve aggressively cut lending rates. Turn the calendar ahead six years and we’re pretty much in the same pickle.

The bulls point to the Fed as our stock-market savior. I’m not so sure. Yes, it’s hard or even futile to “Fight the Fed” when the central bank is printing like mad and desperately trying to reflate the money-supply; but investors forget that despite its best efforts starting in January 2001, the Greenspan Fed unsuccessfully halted a massive slide in stock values. From January 2001 until December 2002, the Fed cut rates from 5.50% to 1.25%, yet the S&P 500 Index still plunged a cumulative 36%.

Since the Bernanke Fed began cutting rates last September, the S&P 500 Index has declined a cumulative 10% -- not exactly a successful rescue.

I still think this market will form a bottom sometime in the fourth quarter – not before. But even then, I don’t expect a bull market to return because the contraction of credit has fractured the economy, corporate earnings and the consumer. It’s hard to be bullish on the market for an extended period amid these conditions and especially when oil is trading north of $100 per barrel.

Earlier last summer when the sub-prime credit crisis first erupted, I predicted stocks would still finish higher 12 months later. I was wrong. The depth of this crisis is enormous and although we’re probably 2/3s of the way through the worst of this debacle, its implications for the economy will linger for many years.

Bank stocks will ultimately lead the next rally since they represent about 35% of total global stock-market capitalization. It’s pretty likely that as stocks form a bottom later this year the market will enjoy a blistering 12-month gain. But beyond any rally, which shouldn’t be interpreted as a new bull market, most stocks will be poor investments over the next several years as inflation, deflation and a long-term contraction in bank credit slow the world’s largest economy to pre-1995 levels.