Wall Street’s Sense of Entitlement

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Watching CNBC’s pre-market commentary one morning this week, I heard the ever-opinionated, always-loud Jim Cramer insist that the International Monetary Fund must come to the rescue of the stumbling, bumbling countries of Europe. They can’t possibly agree among themselves, he contended, so an outsider–presumably with a clearer overview–is needed to effect the necessary rescue. This view, of course, presupposes that a further rescue is the correct solution to the ongoing and growing European debt crisis. It reminded me of Cramer’s now famous “They know nothing” rant that CNBC insists on reprising. In that tirade he berated monetary authorities for failing to recognize the need for rescue, so that, among other calamities to be avoided, friends with 25 years of Wall Street experience would not see their careers destroyed. It mattered little that such Wall Streeters were integral to the crises of the day nor that most non-Wall Street employees would not be similarly bailed out. Such is the sense of entitlement deeply ingrained in the denizens of Wall Street and their financial cohorts. Their view: We are too important to fail, and some central planning entity must make sure that we don’t.

Occupy Wall Street and its multi-city imitators clearly resent both this sense of entitlement as well as the government facilitators who assure that rescue money is available first to the wealthy and powerful who have cowed legislators and regulators into believing that the world as we know it will end if they are not rescued. If such protesters are looking for a specific entity against which to protest, let me suggest the IMF. As donors of more than 17% of IMF funding, U.S. taxpayers have a real financial interest. Having already been forced to bear huge risk in bailing out financial miscreants in this country, we should find abhorrent any commitment of taxpayer funds to prop up governments or banking systems elsewhere. Those who care must make their voices heard now.

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Powerful Rally Continues

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On Monday, October 3, the S&P 500 closed at 1100, the low close for the year and down about 20% from the 2011 market high six months earlier. The news, both domestically and worldwide, was almost universally bad and deteriorating. A growing number of analysts began to forecast a global recession. The following morning opened down another 2% on a continuing lack of progress with the European debt situation.

Suddenly prices turned and began a remarkable march upward through today’s S&P close at 1224, a gain of over 11% in nine trading sessions. Only two of those days produced even small declines, with most yielding gains of more than one percent. The powerful recovery rally leaves the S&P down only slightly more than one percent year-to-date.

The critical question now facing investors is whether this is the first up leg in a new bull market or merely a dramatic correction in an ongoing major decline. There are arguments in both directions.

The speed and persistence of the rise and the strong breadth that has accompanied the move argue for more to come. Negative sentiment (a contrary indicator) was fairly high when the market turned up two weeks ago. While the sentiment level suggested that some sort of rally was imminent, the readings fell short of those that typify major market bottoms. The market has been extremely responsive to news stories recently. Leaks and rumors of possible rescue efforts for Greece and European banks have provided mighty support for the rally-to-date. There is certainly potential for more of the same over the next two to three weeks.

Negative factors, however, abound. Notwithstanding occasional mildly positive readings, most economic conditions are poor and weakening. Major European banks and governments are seriously overextended. Whatever the resolution of the European crisis, the debt burden will remain dangerously large. While U.S. and European markets have surged over the past two weeks, major Asian markets have failed to demonstrate the same level of enthusiasm. Somewhat ominously, the Chinese market remains 60% below its 2007 peak, despite that country’s economic surge since then.

Additional negatives exist on the technical side. Most noticeably, volume has been weak and diminishing as prices have rocketed upward–normally warning that the rally is not the start of a major move. Firms that analyze fund flows indicate that very little true investment demand exists in this rally. So far demand has come almost exclusively from hedge funds or other short-term trading entities. Rallies rarely persist for long without true investment demand. Perhaps most discouraging is the analysis of supply and demand forces coming from Lowry Research Corp. Their measurement of buying power and selling pressure– a valuable tool since the 1930s–indicates that the broad trading range in place since early-August shows the characteristics of distribution, not accumulation.

No single factor is a perfect forecaster of future market direction. We believe, however, that the preponderance of evidence points to a major market decline having begun six months ago, which has yet to reach its bottom. The current rally is now extremely overbought on a short-term basis and will likely soon begin to decline. Whether that decline becomes simply a brief correction of a rally that will contain a second up leg or whether it marks the beginning of a major leg down to new lows is open to question. In either case, we think it unlikely that the current rally will kick off a new bull market.

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Traders and Government Rumors Dominate the Week

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Dramatic volatility characterized the equity markets again for the ninth straight week. One hundred or multi-hundred-point moves in the Dow Jones Industrial Average took place every day this week–on most days in both directions. On balance, most stock indexes gained about 2% for the week.

To anybody watching the markets carefully, it is apparent that large short-term trading interests have come to dominate the action. Today’s price movement was a perfect example. Heading into the end of the day, the market was progressing quietly until traders took over, pushing the Dow up by 115 points in about 50 minutes, with volume swelling as prices reached their peak. Then it was time to take profits, and traders pushed prices down by almost 130 points in the last half hour on the biggest volume of the day. Clearly this wasn’t the action of investors. There is nothing inherently wrong with trading, but there is a danger to markets if investors feel threatened by apparently unexplained volatility. According to insiders, the large high frequency trading operations now account for roughly half of New York Stock Exchange volume and clearly accentuate price moves in both directions. While such activity provides significant revenue to the exchanges, it may undermine their long-term profitability by chasing away real investors, who are understandably withdrawing from what increasingly looks like a casino.

Over the past two months traders are taking their cues from headlines, most of which revolve around the expanding European debt crisis. This week they followed the script to a T. Going into the last hour Tuesday, prices on the Dow were down by nearly 500 points for the week. A report out of Europe sufficiently excited traders that they then pushed the Dow up by almost 400 points in less than an hour. What was that momentous report? European financial officials were going to “talk” about recapitalizing European banks. They hadn’t agreed to anything substantive. They merely indicated that they would talk about something that, almost certainly, they have been talking about for months. These price moves are not coming from long term investors but from traders playing with rumors.

Such frenetic activity is not likely to end soon. New rumors emerge from Europe each week as the fundamental condition worsens. There is no easy answer to the overwhelming debt problem, and to get unanimous agreement from nations with very different financial and cultural makeups will prove extremely difficult at best.

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Be Careful And Stay Flexible

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The stock market sold off hard into the close of a bad day, week, month and quarter. A 2.5% decline in the S&P 500 today contributed to a costly decline of 13.8% for the third quarter. Going into the fourth quarter, the S&P is down 8.5% year-to-date, and the index is ten points below its level at the end of the third quarter, 2010.

While most world stock markets are already down 15-30% from their recent highs, the vast majority of analysts and strategists remain adamant that the United States is not heading into a recession. With housing and unemployment continuing as intractable problems, and most economic statistics at or near recession levels, a bullish economic forecast seems increasingly untenable.

More important to the health of the economy and the securities markets than ordinary business conditions is the fate of the European banking system. Can it emerge in reasonable health from the European debt crisis? Should monumental debt burdens overwhelm the best efforts of Eurozone governments and central bankers, the free movement of credit through the world financial system could come to a screeching halt. World GDP would plummet with recession affecting most of the world.

Whether or not we enter recession is important to equity markets. Over most of the past century, stocks have logically fallen far more deeply when the economy contracts than when it avoids a formal recession. And while averages are not forecasts, they lay out potential paths. Since the early-1900s, stocks have typically fallen almost three times more after a recession starts than in the period leading up to the economic decline. Assuming we are not yet in recession, that past pattern presents an ominous possibility should economic conditions weaken further.

Having forecast repeatedly that we have not yet emerged from the long weak cycle that began in 2000, Mission has maintained a risk-averse posture for its client portfolios. As a result we are up slightly for the disastrous (for most) third quarter and for 2011-to-date as well. Even our relatively modest allocation to equities has produced some appreciation in a very tough environment.

The danger of a precipitous decline is certainly a real possibility should we experience some form of European debt default. If a true “get me out at any price” capitulation results, we would be looking for an opportunity to add significantly to our equity position for at least a short-term recovery rally. Whatever unfolds, the next few weeks and months should prove interesting. Be careful and stay flexible.

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Stocks Still In A Danger Zone

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With a week to go, the equity market is facing severe losses for the third quarter. The S&P 500 is down 13.5% quarter-to-date and a negative 8.2% so far in 2011. Today’s fractional increase was a calming respite to a week that saw the index reduced by 6.5%. Wednesday and Thursday alone saw a combined loss of 6%, one of the most destructive two-day periods in years.

It would be nice if today’s calm were a forecast of the weeks and months ahead, but that is highly unlikely. Political tensions are extremely high in this country at a time when cooperation is necessary to avoid mandatory, formula-based budget cuts. Whatever the long-term benefits of such cuts might be, almost certainly they will further retard a rapidly stalling U.S. economy.

While still robust, economic growth rates in emerging countries are clearly declining. Ominously, stock prices throughout the world are falling hard. Technicians can appreciate the danger of negative trends. Ned Davis Research pointed out this morning that stock prices in all but one of 45 world markets were trading below their respective 200-day moving averages. And 78% of those moving averages were declining. Problems are clearly not local in nature.

The most acute and immediate problems are quite obviously in Europe. Bad as stock performance was in the U.S. this week, prices fell even more precipitously in the major European markets, including Germany, the Eurozone’s industrial giant. EU finance ministers will be negotiating furiously again this weekend in an attempt to cobble together a plausible rescue plan, most immediately for Greece, but ultimately for several other potential insolvency candidates as well. The success or failure of those negotiations could lead to dramatic market moves in one direction or the other in the days immediately ahead.

For the past six weeks, stocks have risen and fallen sharply within about a 10% range. Prices successfully tested the bottom of that range again on Thursday of this week. The bounce from that so-far successful test has been tepid, however, which leaves stocks still vulnerable to a break below that recent trading range. Recent price behavior has demonstrated clearly that traders are trading the headlines, which are, needless to say, plentiful given the potential for sovereign defaults and the attendant danger to banks that hold those sovereign bonds. This weekend’s negotiations, therefore, hold the potential for market-moving headlines.

Notwithstanding the likelihood of occasional sharp news-related rallies, we believe that both technical conditions and underlying fundamentals argue strongly for an ultimate, if not immediate, decline below current prices. Investors should be very careful about their levels of risk assumption.

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The Immorality of Fed Policy

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There is considerable disagreement over the potential effectiveness of another round of Federal Reserve easing.  Opponents of further rescue efforts point to persistent dismal unemployment figures and deteriorating economic statistics as proof that QE1 and QE2 were ineffective.  Supporters of an easy Fed monetary policy argue that without those earlier efforts, today’s economy would be in far worse condition.  Even within the Fed itself there is disagreement over whether additional stimulus will provide any appreciable benefit to the economy.

With economic conditions now in a clear downward spiral, it appears highly probable that the Fed will act again at next week’s meeting to offer some additional rescue aid.  Former Fed Vice Chair Alan Blinder recently suggested that QE3 was the most likely of a few alternatives.  More commentators have settled on Operation Twist as the probable choice.  That option would entail the Fed selling short-maturity securities or letting them run off, then reinvesting proceeds in longer-term notes and bonds.  Puzzled by the lack of success of their earlier actions, the Fed governors are undoubtedly apprehensive about additional efforts.  While most Fed watchers similarly shrug their shoulders when asked whether or not the Fed can get the economy back on a positive course, they argue that the Fed must do something.

Few seem to weigh the possible consequences of additional Fed action.  Clearly there are potential negative consequences; otherwise monetary authorities would add stimulus regularly. Increased potential for inflation is the most obvious negative possibility.  In the present environment of increasing deflationary forces, however,  that fear is easily dismissed.  Unfortunately, what is rarely even examined is the morality of Fed rescue efforts.

Every Fed action involves the choice of winners and losers.  In evaluating such actions it’s important to recognize that the Federal Reserve Board is an entity established by bankers for bankers.  That recognition explains why maintaining the health of banks and bankers always appears to be the most important objective in any rescue effort.  That intention becomes all the more galling in the current instance in which ultra-wealthy bankers, whose firms were bailed out and force-fed essentially free money for lending or investment, received giant bonuses while vast numbers of U.S. citizens remain unemployed.  The money to bail out and feed those banks has to come from the far less affluent general public.

The greatest inequity falls upon the elderly retired and generations unborn.  Millions of Americans worked for decades, saved, and retired with the valid expectation that their retirement assets would provide a variable but reasonable return.  By reducing short-term interest rates essentially to zero, the Fed denied the elderly retired a risk-free return.  Fed officials have acknowledged their intent to “force” investors to take risks.  Imagine the psychological distress that prospect creates in those who don’t want or can’t afford to take risks with their money.  Worse yet, imagine the psychological and financial distress it causes those who take risks and lose money.  Unlike big banks, such people are not “too big to fail,” and the Fed has no bailout program for them.  Now that the Fed has pledged to keep interest rates exceptionally low through at least mid-2013, a growing numbers of retirees will be forced to take risks for a chance to receive any appreciable return.

It is, frankly, very surprising that there has been no hue and cry raised by savers–especially the elderly retired–about their money being used to bail out overextended borrowers.  Have the Grey Panthers gone dormant?  We see a very clear choice by the Fed to reward the profligate at the expense of the frugal.  That choice turns everything we’ve been taught in life on its head.

The elderly retired are not the only victims of the Fed’s rescue policies.  As the greatest debtor nation in world history, we have no stash of cash waiting to be distributed to stimulate the economy.  Any money distributed has to be borrowed or printed.  To the extent that it is printed, it decreases the value of existing dollars.  That devaluation falls most heavily on the elderly retired, who can’t go out to earn more of those newly printed dollars.  To the extent that money is borrowed, the debt burden that will be passed along to subsequent generations grows.  QE1 and QE2 testify eloquently to the uncertainty of success that attends such rescue efforts.  We can’t know in advance whether another intervention will succeed or fail.  We can be confident, however, that we will be leaving a legacy of massive debt to our grandchildren and very possibly to their grandchildren.  What right do we have to bail ourselves out of problems that we created with money from future generations who have no voice in the decision to spend?

The Fed feels compelled to act with no clear blueprint for success.  I suspect that unborn generations would vote “no.”  I encourage the elderly retired to make their voices heard by strongly objecting to being victimized for the purpose of bailing out the overleveraged.

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The Worry Level Rises

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We are now nearly two months into a remarkable period of time for global stock markets.  The strongest of the developed country economies, Germany, has seen its DAX fall by more than 30% in recent weeks.  China’s Shanghai Composite is down more than 15% from its 2011 high, and it is hard to understand why stocks in the emerging world’s leading country are still down almost 60% from their highs of four years ago. Strong profit growth notwithstanding, do investors in these important markets see something dire ahead?

Major U.S. markets collapsed by almost 20% from late July through early August.  As the graph from the excellent DecisionPoint website demonstrates, prices have soared and dived in six legs since the August 9 bottom. Today the S&P 500 closed on the supportive trend line connecting the lows of August 9, August 22 and September 6.  While today’s close of 1154 marked the lowest of the week, it was marginally above Tuesday’s intra-day low.  The net loss for the week was -1.7% on the S&P 500.

The week ended on a note of great uncertainty with the focus still on Europe.  As leading finance officials met in Marseilles, France, rumors were rife of an imminent Greek default–possibly even this weekend.  Greece denied it, but the bond markets argued that it was inevitable.  One-year Greek notes approached a yield of 100%; the two-year topped 65%; and the ten-year sold at more than 21%.  Nobody expects to collect all that income.

There were rumors that Germany was preparing a plan to rescue at least the German banking system in the event of a Greek default.  Evidence that all was not completely harmonious, however appeared with the sudden resignation of Juergen Stark from the European Central Bank’s Executive Board.  Further rumors had Angela Merkel forcing him out because of his reluctance to approve additional purchases of the bonds of financially endangered countries.  There is no clear plan to calm these turbulent waters.  Should Greece be rescued in some fashion, with appropriate haircuts for its bond prices, it’s hard to imagine that Portugal, Ireland and possibly others would not expect similar treatment should their finances reach a comparable breaking point.  Expectations of contagion would infect world markets.

So we head into the weekend with far more questions than answers.  Yesterday and today investors around the world sold stocks to lessen the risks of what might unfold in the boardrooms of Europe.

Today’s public appearances by leading politicians and bankers all had an upbeat tone.  These officials must try to generate confidence.  They can’t allow the markets to expect the worst, which would promote a self-fulfilling negative feedback loop.  There is real doubt, however, that these officials have much effective and mutually acceptable ammunition left in their possession.  They will certainly attempt to craft a solution that at least defers the pain.  We’ll see if they can succeed.

In the meantime, investors must remain conscious of the dangers of these problems overpowering the available political solutions.  Should investors start to factor in failure, stock prices could fall dramatically.  While contributing to longer-term problems, a rapid price collapse could present an attractive short-to-intermediate-term opportunity for a significant bounce-back rally.  At the very least, the weeks ahead should be exciting.

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Another Wild Week

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The stock market followed up the prior week’s strength with a sharp rally on Monday’s opening, which continued largely uninterrupted into Wednesday morning, producing a gain of 4.5% on the S&P 500. From there prices turned down and fell 5% to today’s low. A slight bounce and we ended up with a meager loss of 0.2% for the week. In Dow points it was about 420 up to the week’s high, 500 down to the low and an overall loss of just 44 points.

Just after today’s close the Federal Housing Finance Agency sued more than a dozen big banks for billions of dollars for alleged illegalities in conjunction with the securitization of subprime mortgages. The news was somewhat anticipated, but it is unpredictable how the markets will react to this added note of uncertainty.

Already weighing heavily on the banking sector, especially in Europe, is the specter of possible sovereign defaults. This week saw German politicians arguing publicly about the appropriateness of providing continuing support to struggling members of the Eurozone. The markets themselves exhibited great concern. All the equity markets were hit hard late in the week. And the major European markets have traced out declines ranging from 21% to 34% from their 2011 highs. Such unanimity of weakness testifies to the breadth of the economic malaise.

The poster-child for sovereign risk, Greece, saw its two-year note close today with an interest rate over 47%. Obviously, default is anticipated. More ominous, because of country size, are the climbing rates in Italy and Spain. Italian Prime Minister Silvio Berlusconi appears to be balking more stubbornly against the implementation of austerity measures mandated by the European Central Bank. Finland is demanding collateral for its loan to Greece. The International Monetary Fund says that the rescue will fail if collateral is required. Clearly rescue efforts are uncertain, and the problem will become more severe if economic growth continues to decline.

U.S. economic statistics are still deteriorating, and employment growth has ground to a halt. Economists and investment analysts are increasingly calling on the administration and the Federal Reserve Board to come up with some sort of rescue. With interest rates near zero in this country and the need to reduce debt widely acknowledged, further rescue options are limited and of questionable efficacy.

The introduction of new government rescue efforts could produce short-covering rallies, but the danger of severe financial system damage is very real. We continue to caution readers to limit risk assumption. Safe income is difficult to find, but we have been able to increase portfolio yield without sacrificing liquidity. If markets experience sharp declines, such liquidity could usher in short to intermediate-term profit opportunities in either stocks or bonds.

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Frenetic Short-Term Picture

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Most of today’s schedule was filled with a Mission board meeting, so this will be a brief summary of recent market and economic activity.

The most anticipated event of the week was Fed Chairman Bernanke’s talk from Jackson Hole, Wyoming this morning. Would he suggest another Federal Reserve rescue attempt? Bernanke offered no immediate stimulus but kept alive all possible options for the Fed’s upcoming September meeting. Fear of a disappointing announcement pushed the Dow down by 100 points on this morning’s opening, and initial concern that Bernanke had no new proposals pushed prices down by another quick 100 points. At that level the selling was exhausted, and prices rose in a modest volume rally from 200 down to about 200 up. A few more zigzags and the Dow closed up by 134 points. After strong declines over the prior four weeks, this week produced almost a 5% recovery rally. That leaves the S&P 500 down by 10.6% for the third quarter and down by 5.1% for the year-to-date.

Similar frenetic activity took place in stock markets around the world. To those who do not pay detailed attention to markets outside the United States, it may come as a surprise that we are doing far better than most. Despite collapsing prices in recent months, the U.S. and Canada are the only two of the world’s largest markets not to have fallen by more than 20% from their 2011 highs. Bad as it has been here recently, it has been far worse elsewhere. There is worldwide concern about declining business conditions around the globe.

The depth of the market decline so far could be a helpful forecaster of whether there is more decline ahead. There have been only three instances in modern U.S. history in which stocks have fallen as far as the S&P has this year that have not been followed by a recession (1966, 1987 and 1998). In each of those instances the market fell hard despite strong economic growth. Unfortunately, the current decline is taking place in an environment in which growth is almost non-existent. Whether a recession follows is extremely important from a stock market perspective. On average almost three-quarters of a bear market’s decline takes place after a recession begins. If we’re headed into a recession, traditionally allocated stock/bond portfolios will probably endure significant losses. Over the decades, our Controlled-Risk Flexible Allocation process has protected capital extremely well from major market declines and has left us able to take advantage of many of the market’s bounces, even in bear markets.

Further confirming the risk of a new recession is an ISI report that since 1970, in six of the seven times that real year-over-year GDP has slipped below 2%, a recession has been signaled. Virtually all economists expect that the economy will drop below that level when this quarter’s GDP is announced.

We again remind all readers that we are in an environment in which the financial system itself remains in great danger. The problems in Europe are not merely those of liquidity, but of solvency. If the current rescue efforts are unsuccessful, the fallout could be huge worldwide. We continue to maintain great flexibility and remain alert to both dangers and opportunities wherever they may arise.

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Sliding Toward Recession

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In my August 5 post “The Tide May Have Turned,” I listed several technical breakdowns and conditions that strongly suggested that a top for the 26 month stock market rally had been established. Nothing in the subsequent two weeks of market action would lead to a contrary conclusion. Despite two days with gains of more than 400 Dow points, that index lost a total of 626 points or 5.5% since the August 5 article.

Negative as the technical conditions may appear, the fundamentals look even worse. This week produced a deluge of disappointing economic statistics. Along with continuing dismal news on housing and unemployment, the Philly Fed Business Outlook Survey collapsed to a level that has accompanied each of the last seven U.S. recessions going back more than four decades with no false indications.

Remarkably, almost no economists are forecasting another recession. Most are admitting, however, that, while still unlikely, the odds of recession are increasing. While Cheerleader-in-Chief Ben Bernanke admits that the economy will remain sufficiently weak to justify short-term interest rates at zero through mid-2013, he doesn’t anticipate a fall into recession. And portfolio managers, the majority nearly fully invested, remain bullish by a two-to-one ratio. Optimism remains high despite, according to Bloomberg, nineteen major world stock markets down by more than 20% from their 2011 highs. Most U.S. stocks are also down by more than 20% from their highs, although the most commonly watched indexes are just short of that mark.

Somewhat under the radar, but perhaps an even more important forecaster, long government bond yields have plummeted not just in the United States but worldwide. So pronounced is the flight to safety that investors are willing to lend massive sums of money to the governments of the United States, Canada, Germany and Great Britain for ten years at scarcely above 2%. At the short end of the curve, huge amounts of money are being given to the United States government for three months for the princely annual return of one one-hundredth of 1%. Notwithstanding the bullish public comments of government officials and investment professionals, investors are afraid that more adventurous investments will lose money.

We go into the weekend with much conjecture about actions that may be taken by the Japanese central bank, the ECB or European governments. Next week we hear from Chairman Bernanke in Jackson Hole, where he announced QE2 last year at this time. Great hope abounds on Wall Street that the Chairman has another rabbit in his hat. Yesterday former Fed Vice Chair Alan Blinder suggested that there was a “reasonably high” chance of new stimulus. Of the Fed’s options, Blinder thought QE3 to be the most likely. Later in the day, renowned investment manager Barton Biggs indicated that he believed QE2 worked and that we need a QE3. (Apparently QE2 didn’t work well enough.) “We do need more out of the Fed,” he said. And this morning a trader on financial TV implored, “The Fed has to come to the rescue again.”

What an economy, when the main hope is government intervention!

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