“The Fed must think,” writes Dan Denning, “it's done what its counterparts in the Depression did not: prevent the transmission of the crisis from the financial markets to the real economy. By quarantining the banking sector and injecting new capital into it, the authorities hope the financial crisis will have ended with the steep falls in share markets -- and not translate into a fundamental contraction in global economic activity. The share market will ultimately decide how bad it thinks the economy will be in the next year.
“The optimistic view is that it already HAS decided and stocks are clear to rally from here. But keep in mind, earnings analysts have yet to downgrade their expectations for the next two quarters. When they do, shares could head lower. In fact, we believe the market (in the U.S.) will eventually test the 2003 lows. But it may not happen just yet. Take a look at the two charts below:
The Crash of '29: 49% in Less Than a Month
A 52% Rally and Then an 86% Fall
“After the '29 crash, between November 1929 and April 1930, the market zoomed up 52% in just five months. It didn't make a new high. But the price action was surely enough to sucker many investors back in, believing the worst was over. It wasn't. Over the next two years, stocks fully priced in the debt deflation in the economy and fell 86%.
“This is precisely the scenario the Fed wants to prevent. It's willing to risk a hyperinflationary melt-up in order to avoid prolonged debt deflation. We just don't know, historically, what the result will be.”
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