– Yesterday, the Dow surged 11%. It was the second-largest gain in the the history of the index (all 112 years of it). Before you pop the champagne corks, it’s worth remembering that despite yesterday’s show-off surge Dow indsutrials are still 36% off their October 2007 record close. That puts U.S. blue chips deep in bear territory.

– While analysts desperately pour over their charts and numbers in search for a bottom in stocks, economists are on the lookout for a turnaround in the U.S. economy. It’s not looking promising. This from the WSJ:

The current downturn is shaping up to be worse than the recessions of 1990-91 and 2001 and the prolonged downturn that ended in 1982. Banks are cutting back on lending, consumers are spending less, companies are shedding jobs amid sinking profits, and the housing bust that triggered the slide persists.

According to the paper, economists are focusing on five key indicators: 1) interbank lending rates such as Libor; 2) house prices; 3) consumer confidence; 4) jobs; and 5) stock prices. So far, only interbank lending rates, which have been greatly boosted by government bailout money, are showing signs of recovery.

– Take consumer confidence. Yesterday, the NYT reported that the Conference Board measure of consumer confidence, a widely wathced measure, “plunged to its lowest reading on record in October as Americans reported fewer jobs and smaller incomes and curtailed plans for major purchases like cars and appliances.”

– Or take U.S. housing, which to a large extent influences how American shoppers feel about spending. (The more money their house is worth, the more money they are willing to spread around.) According to AP:

Home prices tumbled by the sharpest annual rate ever in August, with little indication of a turnaround in sight, a closely watched index showed Tuesday.

The Standard & Poor’s/Case-Shiller 20-city housing index dropped a record 16.6 percent from August last year, the largest drop since its inception in 2000. The 10-city index plunged 17.7 percent, its biggest decline in its 21-year history.

– Another great way to measure economic woes is the so-called “misery index.” According to Infectious Greed blogger Paul Kedrosky, “The Peterson Institute has brought back the ‘misery index’, a combination of the inflation rate and the level of unemployment, and added to it a measure of asset price declines. The upshot? The modified misery index is now at record highs.”

– At least the government’s on the case. Cafe Hayek blogger Don Boudreaux argues, however, that this could actually be sinking the markets, rather than helping:

We now have proof that government is a god that failed — a poverty-inducing and economically destructive institution that humankind should finally learn must be kept on an extraordinarily tight leash, lest it wreak havoc in the lives and on the fortunes of innocent parties.

The facts are crystal clear.  Since the March 24 promise by the Fed to guarantee $29 billion worth of mortgage securities held by Bear, Stearns, the Dow has fallen 34 percent (as of mid-day on October 28, 2008).  Since the September 8th announcement by the U.S. Treasury Department that it will take over Fannie Mae and Freddie Mac, the Dow has shed 28 percent.  Since the October 3 enactment of Uncle Sam’s massive bailout bill, the Dow is down 20 percent.

Our instincts say Don is right. The problem with this argument, however, is that cause and correlation are two different beasts. Are the markets plunging because of the government bailouts or are they simply plunging after after the government bailouts?

– Eric Roseman on ContrarianProfits says Swiss money manager Felix Zulauf attributes America avoiding worse pain to the recent bailouts:

Zulauf believes we’re entering a soft economic depression. If not for the government’s backstops on October 13 to prevent further stock and credit market seizures, a depression would have followed. Zualauf is convinced the markets would have crashed.

Zulauf may believe in the power of government to positively influence the markets, but his outlook isn’t exactly rosy for U.S. stocks:

His prediction of a severe recession will take the S&P 500 Index down all the way to 550, possibly 500, or 35% lower from current levels. Stocks have already plunged 40% from their October 2007 highs. Zulauf is adamant: “U.S. stocks are still not cheap. The S&P 500 Index trades at 1.7 times book-value and the Dow more than 3.5 times book. This is still expensive.

Bankers rejoiced. Finally, they could shift the festering lumps polluting their balance sheets and move on. Crucially, the estimated £50bn measure leaves the risk with the banks and not the UK taxpayer via the Bank of England. The fall in the interbank lending rate suggests it has done something. The benchmark three-month Libor is now 5.88%, edging down from a high of 6% earlier in the month.

How bad a bind are UK banks in? The big four – RBS, Barclays, HBOS and Lloyds TSB – are short £37bn, calculates JP Morgan. And on Tuesday RBS announced itself as the first to go cap in hand to shareholders for £12bn. Others are expected to do the same, though Barclays later denied any such plans.

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Tight food supplies continue to make the news in the developing world and the World Bank warns of potential unrest in 33 countries as a consequence. Reports of rationing in the US continue, with even the likes of US retail giant Walmart restricting some food purchases and Costco considering a similar measure.

Ironically, one of the world’s bread baskets, Argentina, is suffering food shortages after farmers responded to a new export tax by blockading roads and restricting supply. The ongoing dispute claimed its first casualty on Friday when its Economy Minister, Martin Lousteau, quit.

In Japan $116 oil and dearer food may have actually killed off a decade long problem – deflation. Its core CPI inflation leapt to 1.2% and panicked investors fled the bond market.

In the equity markets, stocks look to be end the week on a firmer note. London’s FTSE recaptured the 6,000 level on Friday at 6,083. The Dow is at 12,848 in mid-Friday afternoon trade and gold has pulled back to $883. Oil, having hit $120 has shed around $5 as the dollar has strengthened.

Finally, there is no sermon again this week as Peter continues his well-earned break. He will be back next week.

Enjoy your week-end.

Regards,

Rob Mackrill
The Daily Reckoning