“We are in uncharted waters when the financial system becomes so disrupted.”

Fed Vice Chairman Donald Kohn

May 20, 2008

The Fed vice chairman joined a growing chorus of experts and raised doubts that the worst of the credit crisis is behind us. And, as has been noted on several previous occasions, that difficulty is likely to manifest itself when a new administration occupies the White House and proposes a series of policy changes that will almost certainly exacerbate a difficult situation.

At a minimum, new taxes will be proposed. At a maximum, however, policy decisions may hit the US and world economy precisely at a time when it needs it least. The odds of this occurring increase should the populist-minded Democrats control both the White House and Congress.

Investment Strategy Implications

There is a period of great uncertainty headed the global economy and markets way. That period will likely be led by US policy changes that will be the result of a new administration in the White House which will converge with the second wave of the credit crisis. For when you combine tax increases with credit crisis related losses complements of credit default swaps (and/or other financial Frankensteins) and the potential pressures of global inflation, the world economy will find itself dealing with a toxic mixture that monetary policy may not be capable of alleviating – thereby producing a real world case of pushing on a string.

While this rather gloomy outlook sits in the wings, investors, many still flushed with cash, will likely latch onto the shorter term positives of the global growth story and the effects of the US stimulus package (fiscal and monetary). Moreover, many technical indicators are still in sufficiently positive territory (see Mid Cap comments on page 8, for example) that day of reckoning may be forestalled.

As this past week’s market action showed, a market must be positioned for a major move that requires a catalyst to produce the predicted result - the FOMC minutes and existing home inventories. The technical conditions for a major market decline that matches the economic outlook described above do not exist just yet. However, should they arise, then investors should be on catalyst watch for that will provide the spark for a truly nasty stock market experience. 

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