2007 in a nutshell...

2007 turned out to be tumultuous year of transitions as greed got swept away by fear in the midst of a subprime meltdown that marked the abrupt end of an economic boom powered by an era of cheap credit, innovative financing and price stability. Despite numerous warning signs that a crisis was imminent, investors chose to not heed those signs and some ended up paying a very high price.
In this toughened environment of cash shortages, tighter lending standards and commodity led inflation, homebuilders and financials suffered most, the former as a result of a huge and growing backlog of unsold homes and the latter as a result of huge exposure to toxic subprime paper. The consumer discretionary sector was next in line as fear spread to households, prompting consumers to hold back on nonessential purchases, squeezing profit margins already hit by rising raw material prices.
A rapidly deteriorating economic environment prompted central banks to intervene on several occasions, injecting much needed liquidity into the system. The calming effect was temporary, however, as the root problem was not being addressed.
As signs and anticipation of a marked economic slowdown hit the U.S. the decoupling theme gained importance as the rest of the world did not show any signs of weakness. Emerging markets in particular, benefiting from stricter monetary and fiscal discipline, large foreign reserves, foreign direct investments and the formation of a distinct middle class, seemed somewhat more resilient and less dependent on the gyrations of the U.S. business cycle.
The current economic crisis, like many before it did produce opportunities. The lack of transparency in subprime related mortgage backed securities and growing fear of inflation and that the market was heading for a recession prompted investors to seek the safety of treasuries and inflation protected securities, sparking a huge rally. On the equity side, sectors such as healthcare, consumer staples and information technologies also thrived for different reasons.
On the currency front, the dollar's value kept eroding, hit by the economic deterioration and anticipation of greater divergence in interest rate differentials.

Capital infusion to the rescue...

There was talk earlier in the year that in the event of a stock market meltdown, the Fed would not hesitate to intervene by cutting rates aggressively just like it had done several times under the helm of Greenspan. It was also said that private equity firms had piled up a large amount of cash and were just waiting on the sidelines for the opportune moment to start buying again.
Things turned out differently, however, with a Fed under Bernanke hesitant to cut rates more energetically due to concern with regards to inflation. Private equity also stalled somewhat as the ensuing credit crunch took its toll on their ability to borrow cheaply. For a moment it seemed that there would be no way of averting a full blown sell off as the notion of an embedded put option seemed more of a fallacy than anything else. The situation changed, however, as large financial institutions began to disclose their large subprime related write offs. Suddenly, we saw cash infusion offers coming from Asia and the Middle East. Morgan Stanley, Citi, UBS and Merrill all received offers of cash in exchange for a stake. It seems that the embedded put option is very much alive.
This pattern also highlights an exchange that can only increase in importance in time. Emerging markets with their young population and large cash reserves are hungry for investment opportunities in contrast to developed nations with their aging populations and large deficits and an increasing willingness to sell their bonds and stocks to finance their retirement.

Behind the curve?

There is growing concern amongst market pundits that the Fed under Bernanke's helm is not doing enough to counter the economic troubles ahead. Since the Fed first took action after the subprime crisis earlier in the year, a very distinct style and one in sharp contrast to the former chariman's has emerged. Academic and consensus based are two keywords that aptly describe Bernanke's fine tuning style and although it may be appropriate in times of relative calm, it does not seem suitable in an environment of turmoil. It is also in sharp contrast to the quick and dirty or more authoritarian style of Greenspan who did not hesitate to take radical action in times of duress. He has, for example, received credit for averting a deeper recession from the internet bubble.
Nevertheless, navigating in the current crisis is proving to be extremely challenging (even Greenspan recently remarked that the current environment is probably the most difficult he has ever observed) not only because of the two forces (inflation and growth) moving in opposite directions but also because unlike previous downturns, the origins of the current one is the credit market and the extent of the damage is still difficult to asses with any degree of accuracy due to the opaque nature of the instruments behind the subprime boom of earlier years. Most recent inflation figures are indicating the beginnings of a surge which in a way restricts the Fed's room for maneuver on the side of easing.
What is clear is that the market have so far been disappointed with the way in which the Fed is handling the crisis. The most recent 25 basis point cut in the discount window was perceived as just a symbolic move and nothing else. Yesterday's announcement of a proposal of introducing more stringent rules on mortgage borrowing is also seen as not enough to curb the crisis. Time is of the essence and every mistake now will incur a large penalty later.

Too little, too late?

That is at least what the markets seem to be signalling after the FOMC decision to cut the key target rate and the discount rate by 25 basis points each and announce a change in focus from the more balanced growth and inflation worries to growth worries only.
The Fed's behavior since it first started taking action in August suggest a reluctance to ally market fears that the risk of an economic slowdown is greater than that of a surge in inflation. The Fed seems more concerned that further cuts will fuel a rise in inflation. From their remarks, they also seem to be confident that fine tuning on various fronts (key rate, discount window, extension of loan periods etc) in coming weeks and months will suffice to calm credit markets thereby averting a full blown recession. Markets clearly disagree, some economists going as far as suggesting that a recession may already be under way.
Nevertheless, there seems to have been a shift in strategy within the Fed as nine out of the ten voting members voted in favor of the 25 basis point cut (the dissenting voice was in favor of a 50 basis point cut) in contrast with the prior meeting in October in which the only dissenting voice was in favor of keeping rates steady.
As the economy continues to suffer in an environment in which borrowing is becoming increasingly difficult and costly, the impact that is already being felt amongst businesses will eventually trickle down to consumers (that are already feeling the strain of the housing recession and rising commodity prices). In other words time is of essence if the Fed has any chance of averting a more severe downturn in growth.

Markets in a state of euphoria...

It has been a week of revived optimism as upbeat economic releases (better than expected productivity figures compounded by lower than expected unit labor costs and a stronger than expected rise in employment) congregated with a government plan to put a stop to the subprime hemorrhage and the near certainty of another quarter point cut next week.
These events sent global stock markets higher as the risk of a full blown recession in the U.S. somewhat receded. Oil prices dropped as tensions between the U.S. and Iran subsided and treasuries receded as the probability of a larger Fed rate cut diminished and more money poured back into stocks.
The buzz is unlikely to last very long, however, as most of the economic indicators provide a snapshot of the past making an assessment of the current state of the economy nothing more than a wild guessing game. As far as indicators go, the 3 month Libor to 3 month t-bill spread still remains relatively high, suggesting that there still remains a significant amount of distrust and uncertainty plaguing the credit markets. The subprime mess is far from being resolved and another cut in interest rates will also raise the risk of inflation in the future (as the current shape of the treasury yield curve would suggest).

The housing dilemma...

Housing has been at the center stage of the current economic crisis ever since the sub prime blowup of August. Apart from the fact that pretty much every indicator out there suggests that the real estate market in the U.S. is in a recession, there is growing concern that the worst is still to come and the implications of this on the rest of the economy. The worry is clearly regarding the risk of contagion or a spillover. So far nothing would suggest that the damage is spreading beyond the housing borders but this could very well be because of a lag factor. Studies suggest, for example, that for every 100 dollar drop in financial wealth, the consumer will spend from between 2 to 5 dollars less on consumption. For every 100 dollar drop in housing, on the other hand, consumption drops between 5 and 9 dollars. Apart from the difference in the drop in consumption, it has been shown that the effect of a drop in financial wealth is pretty much immediate, in contrast to a drop in the price of housing in which there tends to be a clear lag (sometimes substantial) before it translates into less consumption. Hence, this could explain why consumption has not retracted despite falling prices. Considering that consumers make up roughly 70% of GDP, this is a very big deal (and unlikely to be offset by exports or a so far resilient stock market).
Considering a stock market that is still in the black for the year and gasoline prices that have yet to reflect the sharp rise in oil, the housing slump on its own wont cause much damage. But if we factor in a possible scenario in which there is a sharp correction in the stock markets, more credit tightening across the board and a sharp rise in gasoline prices (which is bound to occur if oil continues to hover around $100), things could rapidly turn ugly.

Staying the course...

If we take the definition of a bear market, which is a stock market drop of at least 20% in a 12 month period, Japan, or more specifically the Topix index should in fact be considered to have entered bear territory. This is bearish news indeed, considering Japan happens to be the second largest economy in the world! What about China, where the Shenzhen index has shed close to 18% from it's peak? If the index breaks the 20% barrier would that be considered a bear market (considering that from trough to peak this year it has returned close to 176%)?
Irrespective of the debate on how to detect a bear market it has been demonstrated time and again that during periods of crisis (like the one the global markets are currently experiencing), emotions tend to override rationality. It comes as no surprise considering that our ancestors used these very behavioral attributes very effectively for survival. Employing them in investing, however, has proven to be highly destructive. Take the '87 crash as an example. The stock market correction sparked a bond market rally (similar but more pronounced than today). Most investors that held on to their stock portfolios right after the crash eventually gave up and switched their investments into bonds more or less around the time when the bond market rally peaked. What resulted was a double carnage for not only did they lose a large chunk of value from their stock holdings but, right after the switch, when stocks picked up and the bond rally ended, they experienced a further erosion of their wealth. The lessons to be learned from this is to avoid being overwhelmed by our emotions in difficult times, to stay the course by focusing on the longer term objectives and rebalance whenever necessary.

Options on the table...

We know that Fed has two mandates (both enacted by congress) which may be broadly defined as insuring market stability to maintain unemployment at its natural rate (whatever that may be) and price stability to ensure that inflation is basically tamed. History also shows us that, at times, the economy may find itself in a position whereby on the one hand we have deteriorating market conditions with unemployment rising and, on the other hand, there are signs of inflationary pressure. Stagflation is usually the term coined to describe an environment in which there is rising inflation combined with stagnant growth and rising unemployment (a prelude to a recession). The U.K. experienced stagflation in the 60's and 70's whilst the U.S. economy was in stagflation during the Carter administration of the 70's. The reason why is so dreaded by governments and central banks is because the main tools at their disposal, namely fiscal and monetary policy become ineffective. This is not to say that the U.S. is in a stagflationary state or that it is heading in that direction (the world has evolved so much and the same principals may not apply anymore). But it is clear that the Fed is having to make a difficult choice between providing market stability and capping inflationary pressure. Right now they are erring on the side of market stability to avert the risk of a recession. We could argue that they are walking a thin line because not only do they need to fine tune between the employment/inflation trade off, but, now that they are leaning towards the side of providing market stability they need to concern themselves between the market stability/moral hazard trade off. Market stability will indeed raise the probability of averting a full blown recession, but it will most likely come at a price in the form of more reckless activity amongst market participants once the stability sets in. These are indeed very challenging times for Bernanke and his crew!