Reconstruction 12/08

Good afternoon,

Today in history, we declared War on the Japanese and entered WWII one day after the sinking of the Flower of the Pacific Fleet. Please let me salute all of our past Veterans and current Service men and women and their families.

The bulls didn’t drop any nuclear bombs on Friday but they gave it the good college try. David Carradine turns 72 today. While my only exposure to him is the character Bill in the movies Kill Bill Vol 1 and 2, I find the repertoire of his work stunningly vast. Any actor that can go from French movies, to “Dr. Quinn, Medicine Woman” and land in a Quentin Tarrantino movie has range….Or a good agent.

From last Thursday it’s been clear the market has range. I think much of Thursday’s sell off was a last minute unwillingness to be in the market in the face of the expected large number drop in Non-Farm payrolls. Friday, however, despite the media’s “woe is us” message, traders were focused on the meek movement in unemployment. It was inconsistent with the payroll pitch into oblivion. Through Friday the S/P500 held the bears at bay. Not falling below 815 proved to be the stalwart defense the bulls needed. By the afternoon, buyers rushed in to get their possible last minute sales and moved the market higher and higher. While the volume was strong, I wouldn’t put all my eggs in one basket yet.


In my spare time, I did a quick study for 2 years between the information reported in the left hand column of the WSJ and the DJIA performance. The trend that emerged was this. When the economy is getting ready to start turning around it does so in the midst of some very bad news. Friday and the next 10 trading days or so could prove to be important. On Friday we close up which is critical because of the bad news that prevailed. For anyone counting, we’re at three pieces of good news in the last two weeks.

Global Range – don’t be shy about paying attention to what’s happening around the globe. It’s important to how to invest at home. On the front page of the NY Times there was an article expressly insinuating that the Pakistani ISI has been protecting the group allegedly responsible for the attacks in Mumbai. Pakistan was looking to India for a loan prior to the attacks. Predatory lending will take on a whole new definition if these allegations prove to be true. Should the Pakistani government, already on shaky ground, run out of money, considerable unrest will ensue.

Looking a little farther east to China, Premier Hu has cautiously addressed that economic stress could jeopardize the Communist Party’s grip on power. There is some information leaking out that the Army has already been deployed to the provinces to keep civil order. The Atlantic quotes Gao Xiqing, President of the China Investment Corporation, who manages $200B of the $2T of China’s foreign investments, has indicated an effort towards not aggravating the dollar by pulling out of the Treasuries market. Whether unrest at home and with the government would change this attitude remains to be seen.

Since today’s theme is range let’s move from gloom and doom to some good historical data with which to put things in perspective. In Barron’s over the weekend, Barry Ritholtz noted that in the last 100 years the relative strength of the S/P500 has only fallen to its current level 5 times. Each time it fell it was followed by a significant rally. It didn’t ensure a bottom, but did ensure a rally.

Given the potential significance of the next ten days here are some of the support levels to watch -- Dow at 8118 and the S/P500 at 815. An upwards swing would have to break through an S/P 895 (which we have at this moment and I don’t think 3 min can undo that) and 920. Should that occur we’re looking at post Election Day highs. The credit markets could still pull us down for the month (a statistical anomaly in the history of the Dow). At the bottom of this email is some information from Nouriel Roubini for any diehard technicians.

Let’s make it through the weekend before we hang the stockings.



"A severe global recession will lead to deflationary pressures. Falling demand will lead to lower inflation as companies cut prices to reduce excess inventory. Slack in labour markets from rising unemployment will control labor costs and wage growth. Further slack in commodity markets as prices fall will lead to sharply lower inflation. Thus inflation in advanced economies will fall towards the 1 per cent level that leads to concerns about deflation.

"Deflation is dangerous as it leads to a liquidity trap, a deflation trap and a debt deflation trap: nominal policy rates cannot fall below zero and thus monetary policy becomes ineffective. We are already in this liquidity trap since the Fed funds target rate is still 1 per cent but the effective one is close to zero as the Federal Reserve has flooded the financial system with liquidity; and by early 2009 the target Fed funds rate will formally hit 0 per cent. Also, in deflation the fall in prices means the real cost of capital is high - despite policy rates close to zero - leading to further falls in consumption and investment. This fall in demand and prices leads to a vicious circle: incomes and jobs are cut, leading to further falls in demand and prices (a deflation trap); and the real value of nominal debts rises (a debt deflation trap) making debtors' problems more severe and leading to a rising risk of corporate and household defaults that will exacerbate credit losses of financial institutions." Nouriel Roubini – FT Wednesday Dec 3, 2008

As a result, the velocity of money and how it impacts economic growth should be watched with care.




Sources: Art Cashin-UBS, Barron’s, and “The Atlantic.” This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 8, 2008, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Merrill Lynch to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to the Alternative Minimum Tax (AMT). You cannot invest directly in an index. Discuss your investment needs with your financial professional before investing.