Have you ever wondered what the heck is a CDO anyway?  Or how did CDO’s bring down the world’s greatest economy and lead to a worldwide financial crisis?  This is a great demonstration of how CDO’s work and how they were related to the financial crisis.

Last week was not pretty for equities virtually anywhere.  Read more.

Stock markets generally had a good week last week. US equities were up for the first time this year, with the Dow higher by 3.5%, the S&P 5.2% and Nasdaq 7.8%. Europe was higher by about 4%, and Asia was flat. The 10-year Treasury sold off again and now is only a tick short of 3%. Munis rallied modestly.

Of course, one reason for the surprise at the equity gains was the end-of-week release of the employment data in the US. Almost 600,000 jobs were lost in January, and the unemployment rate jumped to 7.6% from 7.2% in December. Initial claims climbed over 600,000 in the week ended January 31. The only positive in the release was that average hourly earnings rose 3.9% YOY, about the same as in the previous month. Recall that unemployment is a lagging indicator of economic activity.

The other news in the week indicated that the recession is still virulent. However, one thing the markets have historically always looked for is a slowing in the rate of descent, and there was some evidence of that in last week’s data. The ISM manufacturing survey indicated that the sector continued to decline in January but it did so at a lesser rate. The ISM nonmanufacturing sector, a representation of the biggest part of the economy, also continued to slide downward but it too did so at a slower pace.

The ICSC retail sales numbers for January continued to show a decline YOY, whether in total sales or in same store sales, but those sales numbers showed a fall by less than in the previous month. January US auto sales, however, did have their worst month since 1981. New orders for December registered a 3.9% drop versus 6.5% the month before, and non defense capital goods shipments ex aircraft were actually up modestly in the same month. Productivity in the fourth quarter of 2008 increased at more than double the third quarter pace, and unit labor costs gains slowed. Both these data points should be an indicator of at least a stabilization of profit margins. Prices did fall slightly, however, eroding some of the impact of the productivity improvement.

On the housing front, there were some positives. Pending home sales rose 6.3% in December as home prices and interest rates softened. While a volatile series, mortgage applications advanced by 8.6% in the week ended January 30. 

So, despite the continued outpouring of bad news and sustained high levels of anxiety about where we go from here, we believe now it is evident that the rate of decline in the US economy has slowed. The same is true for Europe although not for Japan. This does not mean that the that the recession is over, much less that the end is even in sight. It just indicates that on the basis of what we could be nearing a bottom. A new fiscal stimulus package, if properly designed might help to speed the end of the slide. Unemployment will almost certainly continue to rise, but again it is important to remember that this is a lagging indicator.

No one knows how to predict the stock market with any certainty, but if history is any guide, and if the slowing in the rate of descent continues, we believe there is a heightened possibility that we will begin to see a better tone to the markets. Good weeks could begin to outnumber bad ones, again if history is any guide and the economic situation has in fact stopped worsening at the torrid pace of the last months of 2008.

There is a new President in the White House, and we all have to wish him well as he tries to deal with the multiple issues that confront the nation.

On the economy and the markets, there was little to get positive about last week. Financial stocks again were hit; earnings numbers were not generally good; the report showed initial unemployment claims again soared. Overall the Dow was off 2.5%, the S&P 2.1%, the Nasdaq 3.4%. Transport stocks were especially hard hit, down almost 6% on the week and already down over 16% since the start of the year. Overseas, markets did even worse. European stocks tumbled 8.7%. Asian stocks were off 5.1%, with Japan down a more modest 4.5%.

As if this were not enough, the 10-year Treasury in the US droped dramatically, as the yield rose to 2.62% from 2.32% last week. Oil futures jumped about $10 a barrel in New York. The dollar was mixed.

The economic data, as noted, make grim reading. Housing starts fell 16% in December, the lowest level on record. Building permits in the same month declined 11%, also to a record level. FHFA housing price index fell another 1.8% in November. Mortgage applications dropped 9.8% for the week ended January 16th, led by a slump in re-financings as borrowing costs rose from record lows. In short the housing market slump continues to worsen.

Most troubling, initial unemployment claims for the week ended January 17th increased 62,000, matching the highest level in 26 years. The announced layoffs in the press last week showed that the trend continues to worsen. 

Some optimism surfaced last Friday that the new stimulus package may be ready soon. It will, of course, take some time before it passes Congress and is signed by the President. News reports indicate that there is also a significant adjustment in financial market regulation in the works. This will lead to uncertainty until its details are known.

The data from abroad are just as bad as in the US. Nationwide department store sales in Japan in December were down 9.4% YOY. Moreover consumer confidence continued to fall in Japan in December. Japanese machine tool orders were off almost 72% YOY in December. Their leading indicators index was also down in November.

In Europe the story is only marginally less bad. Industrial new orders in November were down 26% for the EC as a whole. The PMI survey did, however, show basically flat in January. Some of the big countries did not fare so well on this measure.

There is no question that the global recession is continuing and even deepening. Inflation does appear to be subsiding everywhere, and the risk of deflation is very real. A positive in all this, though is that despite the pile on of bad news in the US and around the world, the S&P has traded sideways, albeit within a wide range, for some months now. YTD numbers mask this important trend. While there are worries that a new stimulus package may be slow in coming and might not even be enough, there is a commitment by the new Administration in Washington to do what it takes to get things moving again. The Federal Reserve has a similar commitment. No one can forecast the future in these record-breaking times, but the market is giving us a positive signal in its sideways movement – again despite the bad economic news.

•If there is a recovery this should be accompanied by some easing in the pressures in the corporate bond markets, both investment grade and high yield. Even with a sell-off in Treasuries, there could be an approach to more normal spreads incorporates as the year unfolds.

 •In general it could be expected that if the global economy gradually begins to recover the worry about a return of inflationary pressures could surface, given all the monetary stimulus in the system and concern about how quickly monetary policymakers can begin to reverse course. That could enhance the attractiveness of gold and TIPS.

•The recovery will restore pressure on world food supplies. This will occur as well when humanitarian organizations will have their greatest demand for food for the poor across the globe as the recovery for this segment of the world community will lag in feeling the overall economic recovery. Food prices will rise in this environment.

These are just a few thoughts on where we might see changes in 2009. There are many who believe that the recovery will be slow and moderate when it come and as a result will disappoint investors many times over the year. Volatility and uncertainty have become the hallmarks of the recent past. Again, no one should have any confidence in forecasting this year, but maybe the gradual restoration of confidence can begin and with it some of the volatility will begin to dissipate. Sometimes it makes sense to look carefully for opportunities in what has been shunned with such forcefulness in the previous horrible period. Best of luck.