-- Posted Tuesday, 24 November 2009 | Digg This Article | | Source: GoldSeek.com

Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 22^nd November 2009.

Fed rate hikes have preceded every major decline in the US stock market over the past 80 years. This doesn't mean that every Fed rate-hiking campaign has been followed by a major stock market decline, because that certainly isn't the case. Rather, it implies that while a Fed rate-hiking campaign will not necessarily bring about a major stock market decline, it could, under the current system, be a prerequisite for such an event. To put it another way, it implies that the probability of a major stock market decline getting started will be very low if monetary policy is either accommodative or becoming increasingly accommodative.

Before going any further, two clarifications are in order. First, once a major stock market decline begins it will usually run its course regardless of the Fed's attempts to prop-up prices. The point is that no major stock market decline has ever STARTED -- at least, not over the past 80 years -- while the Fed has been cutting interest rates or maintaining interest rates at a low level. Second, we are not suggesting that the stock market would trend upward indefinitely in the absence of Fed attempts to tighten monetary policy. Fed rate-hiking campaigns are invariably reactions to signs of an inflation problem, so it is probably more accurate to say that no major stock market decline since the late-1920s ever started until some time after the signs of an inflation problem became so blatant that even the Fed could see them.

Today's official interest rate is effectively zero and the Fed has promised to keep it that way for a considerable period. It seems that the Fed's plan is to maintain an ultra-easy monetary policy until employment begins to pick up, but the reality is that it will only be possible for the Fed to maintain its current stance until an inflation problem becomes undeniable. During the 1970s and early 1980s, for example, the Fed was forced by blatant evidence of an inflation problem to aggressively hike its official interest rate target in parallel with high-and-rising unemployment and a very weak economy.

The idea we are working around to is that the next major stock market decline probably won't start until some time after the Fed begins to hike its interest rate target, which won't happen until after the evidence of an inflation problem becomes obvious to all.

The above statement meshes with our view that the most likely intermediate-term stock market scenario involves the S&P500 Index peaking near its current level, and then, rather than immediately embarking on another major decline, spending up to 12 months oscillating within about 10% of its peak before beginning to trend downward. As well as being consistent with the monetary backdrop, this scenario is in line with the 1937-1942 and 1980-1982 stock market models discussed in previous commentaries.

The counter-argument is that the monetary backdrop doesn't matter because the current stock market rally is only a counter-trend move within the context of the major decline that began in 2007. According to this view of the financial world, the 2009 stock market rally is akin to the first of the counter-trend rebounds that occurred within the major decline of 1929-1932.

We are in full agreement with the idea that the current stock market rally is the counter-trend variety, but the monetary backdrop is always extremely important and today's monetary backdrop is diametrically opposite to that of 1930. This actually makes the long-term outlook for the US economy WORSE today than it was in 1930, but, at the same time, it means that equity prices are unlikely to collapse the way they did during 1930-1932. Also, the longer the current rally lasts the more implausible the 1930 comparison will become (from a stock market perspective). The reason is that although today's rally has done no more than the 1930 rebound in terms of retracement percentage, it has already lasted almost 3 months longer if measured by the Dow Industrials Index and almost 7 months longer if measured by the NASDAQ100 Index.

-- Posted Tuesday, 24 November 2009 | Digg This Article | Source: GoldSeek.com

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