Priority Number One

As the global recession gathers steam, pundits are opining how the Obama administration will address priority number one, the economy. Clearly over the next sixty-plus days before the inauguration, President-elect Obama and his advisors will be busying themselves with analyzing the economic options that lie ahead for the nation.

Some of Obama’s team from President Clinton’s tenure may be noting something that I have considered: perhaps in retrospect, the US economy has been in a bear market for over ten years, starting with the 1997 Asian crisis and exacerbated by a deflationary spiral. Considering that bear markets often have strong bull spikes along the way, this would not be a crazy notion. If so, then the 2008 credit crunch and asset sell-off does not constitute the beginning of the process, but the final salvo that puts an end to global deflation and asset bubbles. Additionally, it would also argue for a continuation of the unprecedented global government intervention that is occurring under President Bush.

Regardless of where we have been, one thing is clear: the American people want action, but what form might that take? It looks like a centrist tone will prevail as the new administration faces the giant hurdles of a rapidly deteriorating economy and the overwhelming effect of the previous administration’s actions on the nation’s balance sheet. The effect of both of these factors should focus the President-elect’s attention on addressing economic concerns and could impede or postpone progress on addressing other long-term goals, like education and health care.

If the revival of the US growth engine is numero uno, then we should expect a significant stimulus plan immediately. Some are talking about $200 billion set aside to satisfy Mr. Obama’s desire to provide the middle class with tax cuts. For high wage earners, expect that the top tax bracket will increase to 39.6% and that capital gains and dividend rates will return to 20% from the current 15% level. The additional revenue raised from these increases is likely to help cover Alternative Minimum tax relief. On the good news side of the ledger for wealthier individuals, the plan would also extend the 2009 rates for estate taxation ($3.5 million indexed per spouse exemption and a 45% top rate). Many are also proposing infrastructure investment and direct grants to states for foreclosure mitigation.

What’s all of this going to cost? Estimates are for deficits to run from $1.5-$2 trillion next year, or at least 10% of the nation’s GDP. For deficit hawks, some of whom are among Mr. Obama’s closest advisors, this number is staggering. The rationalization for the massive spending is that government issuance of debt to help recapitalize the shaky financial foundation, is not spending, but should be seen as a necessary and massive re-fi. That does not mean that longer term interest rates will react as such—expect them to rise in reaction to these kinds of deficits. In the economic triage that is occurring, there is not much time to worry about those issues right now as we muddle through this unchartered territory. Bottom line: be prepared for the economy to be the number one issue for quite some time.

Obamarkets

Before the election, someone argued that one of the reasons that stocks had lifted from the October 10th lows was that it was becoming clearer that the President would be Barack Obama. I countered that despite the excitement about the election on both sides I did not think that the stock market was trading on politics. Others contended that if McCain were to pull out a come-from-behind victory, that there would be anarchy, an idea that frankly demeans the American people.

Now that we have elected Mr. Obama, I am more convinced than ever that while traders like to know presidential outcomes, last week’s action did not jibe with the clarity of the Presidential and Congressional victories. Indeed, the biggest Election Day rally ever faded quickly, as the subsequent two-day drubbing supplanted “yes we can” with, “maybe we can’t”. Was it disappointment with the Obama victory or a more visceral reaction to the dour economic news and massive hedge fund redemptions? I put my vote on the latter.

In addition to a new president, last week saw additional proof that the economy has continued to deteriorate. This fact was confirmed by retailers whose October same-store sales fell more than they have any time in this decade; the Institute for Supply Management, whose index dropped to its lowest level since 1980; the auto industry which reported that sales skidded to their worst pace since February 1983; and the Labor Department which said that the jobless rate spiked to a 14-year high of 6.5% in October, and another 240,000 jobs were lost, bringing the total number of jobs lost to 1.2 million for the year. It is likely that the convergence of bad news rather than the election spurred net selling on the week for stocks, with all of the major indexes closing down approximately 4% for the five trading sessions.

I am sorry to say that the outcome of the election will probably not calm markets any time soon, rather the antidote to the extreme moves is likely to be found in something simpler: sheer exhaustion could set in. As the excellent Jason Zweig noted in the Wall Street Journal over the weekend, “In the 10 years ended Dec. 31, 2007, the Dow never once swung by more than 9% during the course of a trading day. So far in 2008, with less than eight weeks to go, there have been six such giant swings. Over the entire decade through the end of last year, the Dow bounced around by more than 5% in a single day a total of 14 times. So far this year, that has happened 20 times; what used to take place barely more than annually has occurred once every 11 trading days in 2008.”

Zweig notes that there have been previous times of extreme price movement, but US stocks have not “been this volatile, day after day, since the 1930s.” Like a winded ballplayer, markets will need to take a break from the action to recover. Clearly the election was not the much-needed half-time show.