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Viewing today's markets, a strong case can be made that aggressive Fed rate cuts have been counter-productive; Fed easing has exacerbated inflationary trends in the commodity and currency markets, while doing little to prevent the repercussions of the bursting of the credit and real estate bubbles. While the Fed has slashed the fed funds rate by 225 basis points over the past six months, commodity price indexes have exploded 35% higher and the U.S. dollar index has plunged a further 10% to new record lows. Last week, as Chairman Bernanke reaffirmed his commitment to rate-cutting, the U.S. dollar sank below the psychological $1.50 level against the Euro.

In exchange for its part in devaluing the currency and reducing purchasing power through extreme commodity inflation, has the Fed at least succeeded in alleviating the credit crisis and arresting the housing price decline? It would appear not. For every form of debt save Treasury bonds, credit markets have gotten progressively tighter since the Fed began easing. One of the most important interest rates for the residential real estate market is Freddie Mac's 30-year mortgage rate, which today stands at 6.24% - 6 basis points higher than year-ago levels. Further, considering that an increasing share of the household budget must be directed to food and energy, as well as other costs that are increasing at a rapid rate, a persuasive argument can be made that the Fed's actions are undermining rather than helping to resolve the problems of housing affordability and supply. Last week, the California Association of Realtors reported that January home sales in California were down almost 30% from a year ago, with median prices sinking 21.9% year-over-year, and the inventory of unsold homes rising to almost 17 months of supply.

The Fed and others who choose to downplay the inflation problem like to cite the low current yields on Treasury bonds. The 10-year Treasury yield finished last week at 3.51%, which is extraordinary given recent trends in the commodity and currency markets. At this yield level, we believe Treasuries are priced to deliver terrible long-term returns given the reality of a government committed to and fully capable of producing inflation. However, in the near-term, government bonds continue to benefit from a huge flight-to-safety bid. Indeed, the strength of the Treasury market has been closely linked with weakness in the stock market and risk avoidance in the credit markets.

Our view has been and continues to be that it would be better for the long-run health of the economy to let the credit and real estate bust run its course, rather than try to inflate our way out of the problem. How can a problem caused by the excessive expansion of credit possibly be solved by creating even more credit? One could argue that the Fed's reflationary efforts have thus far kept the bear market in stocks modest by historical standards. As it stands now, the S&P 500 is down a relatively mild 15% from its October 9, 2007 peak, far less than the 27.5% median peak-to- trough decline in the 12 bear markets since World War 2. Clearly, the decline we have seen in the stock market has been worse when measured in almost anything other than the U.S. dollar (e.g. gold, commodities, and foreign currencies). The stock market has been losing ground at a particularly rapid rate relative to the price of gold. Since the Fed reversed to a policy of easing, the price of gold has risen by over $300 to $970/ounce.

Short-term market forecasts are more than usually hazardous in a highly volatile environment such as this, with strong cross-currents from recession, inflation, investor emotion, and market intervention. Nonetheless, we will observe that Friday's sharp decline left the S&P 500 at 1331, which is at the very bottom end of the 1330-1370 trading range the index has been in for the past four weeks. We have been anticipating a retest of the January 22nd/23rd low in the stock market. Last week's high volume downward reversal in stocks, combined with continued upheaval in credit markets, the melt-up in commodities, and the breakdown in the U.S. dollar suggests that the test may come sooner rather than later.

As mentioned in earlier commentaries, we do not think the ultimate downside risk in the S&P 500 is more than about 5% below the 1275 level reached on January 22nd and January 23rd. Government sponsored inflation ultimately affects all prices, including stocks. Moreover, the Fed's rate cuts are pushing down yields on money markets and CDs, making holding cash less and less attractive. Currently, $3 trillion is parked in money market funds earning a dwindling return. At some point in the months ahead, these funds will begin to move back into the stock market as investors grow tired of earning a negative real return on their savings.