Three months

Three months can feel like an eternity or can fly by in no time. For investors, the past ninety days started with extreme fear, followed by relief that the painful period had passed; to euphoria that maybe there would no need to feel the enormity of the March lows again; to resignation that in fact, most often markets revisit painful periods before moving forward.

Friday’s drubbing brought stocks around the globe back in time to March of this year, when Bear Sterns was nearing collapse. The Dow Jones Industrial Average settled at 11,842 on Friday, the first close under 12,000 since March 17th and perilously close to the March 10th low of 11,740. The Dow and the S&P 500 are now down over 10% year-to-date.

What brought about this test of the lows? To some extent, there has not been a lot of fresh news, but financial companies have continued to tell us that the unwinding of the credit crisis is claiming more victims. At first, it was the big investment banks, which culminated in the Bear Sterns sale to J.P. Morgan, while last week, there were worries about smaller regional banks that have extended credit to less-than-stellar borrowers. Stocks will have a hard time recovering until this confessional period is complete.

On top of the financial sector kiss-and-tell over the past three months, the period has also seen a renewed sense that inflation is on the move. Between oil and food spikes, it is understandable that consumers would come under pressure. But the big question with regard to inflation is what the world’s central banks intend to do about it. Thus far, the European Central Bank (ECB) has responded to headline inflation with tight policy—unlike the Fed which cut rates from 5.25% to 2%, the ECB has held its target rate at 4% since the credit crisis erupted last August, because of concerns about inflation.

Meanwhile, the US Fed has pursued an easy monetary policy because the economy is weak and the financial system is still in distress. The problem is that when the central bank's benchmark rate is well below the current inflation rate, it can be a recipe for disaster. The reason is that it encourages people to borrow today, invest in something that's going up in price, and pay back the loan in devalued dollars. Yet the Fed is not convinced that inflation is a long-term problem and will likely recede as demand falls. That’s why Fed bankers are left with the policy of talking about inflation, rather than doing anything about it.

To some extent, the outcome of this re-test period rests on the actions of central banks: if they tighten too much and are wrong about inflation, it could choke off economic recovery and things could get ugly. Conversely, if the Fed’s view is correct---that pervasive and widespread inflation is impossible when wages are stagnant, then inflation will moderate as financial companies complete their “’fessing up” on losses, allowing the system to recover from this unpleasant de-leveraging process. That would amount to stocks passing this current test and could resume the grind higher.