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President-elect Obama Faces Extreme Volatility of Deflation and Inflation

Politics / Recession 2008 - 2010 Nov 10, 2008 - 04:23 PM GMT

By: Paul_J_Nolte

Politics Best Financial Markets Analysis ArticleA historic week on a few levels – the largest two day drop in the markets since the crash of '87, putting the markets on pace for their worst year since 1931 and 1937 (which represent the two worst years in the 183 year history of the market). Oh, and the election worked out well for the Democrats, putting the now President-elect Obama in the Whitehouse.

Once elected, the markets did their two-day tailspin as investors realized the economy still had problems and the election did nothing to change that fact. The data during the week was poor, as the service economy report from the ISM fell dramatically, retail sales were poor (pointing to an especially grim Christmas season) and the employment situation showed huge declines in both the reported and adjusted data.

While the markets rallied after the employment report (likely set up by the 10% two-day decline?), the week felt as though investors were put through the ringer. There are a few reports next week, but the likely focus will be on the retail sales report due Friday and lingering earnings reports. We are likely slowly emerging from the worst of the credit freeze, however all the pain has yet to be felt as auto companies go begging, banks are still failing and loans remain sparse. So the economic reports from the period should remain bleak.

A trading range only a dedicated trader could love. From top to bottom, the markets have traversed over 15% four times since the beginning of October. The spate of selling this week came on lower volume than the initial decline three weeks ago, providing a glimmer of hope that the recent declines “testing” the initial low were successful.

One indicator we have discussed in the past – on balance volume (OBV) has also turned higher and has put in a series of higher lows, but not yet a significant higher high. This indicator did a reasonable job of foreshadowing the recent decline by a couple of months. While we don't heavily weigh any one indicator, volume is the final arbiter of emotion – how badly do investors want to get out or into the markets. One other volume measure, the net advance to decline volume has been pointing down for a year and does not yet show signs of turning around. So while we remain steadfast in view that the markets are cheap, we do not yet see indications of an end to the trading environment.

The interest rate market continues to be thwarted in its' attempt to decline by the fears of inflation right around the corner. The economic data last week was certainly poor, at best we are currently in a recession and rates should be dropping in order to boost overall spending. However, even with the Fed pushing rates back to 1%, the longer-term bonds are seeing their yields actually increase (prices drop) on fears that inflation will soon darken investors doors.

We are still of the belief that rates should be falling over the coming weeks, however that flies in the face of the bond model, which remains in negative territory for the fourth consecutive week – even with the huge decline in commodity prices. Could it be a rebalancing by investors from bonds to stocks? Unlikely at this point, given the highly volatile nature of stocks – but that shift will come once stocks find their way.

By Paul J. Nolte CFA

Copyright © 2008 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

Disclaimer - The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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