Last week stocks continued the new year’s march downward even as the country celebrated the historic inauguration of President Barack Obama. In fact, markets greeted the inauguration with a 5% plus decline before rebounding later in the week. Plenty of disappointing corporate news played a significant role last week, including Bank of America’s need for $20 billion from the government due to losses at the newly acquired Merrill Lynch, and Microsoft’s nasty earnings surprise. In addition, the KBW Bank Index (BKX) fell to a new low amid fears that shareholders may be wiped out before the banking crises passes.

While most of the fundamental reasons behind market action in recent weeks are clear, I would argue that the key issue for the markets is the uncertainty surrounding the policies of the new Obama Administration. Looking at history, the market has typically struggled leading up to the inauguration, especially if the incumbent party (in this case, Republicans) was voted out of office. The reason seems to be that no one really knows what the new President will do, and the uncertainty this time is particularly acute given the economic challenges we face, as well as the lack of a robust Obama track record prior to his election.

The next 60 days or so will be critical for the new President. Now that Treasury Secretary Geithner has been confirmed, the President should soon provide details of key policies, including the proposed stimulus package, TARP plan, and global trade. But we must concede that, despite encouraging rhetoric over the last few weeks, our read on initial details has been disappointing. The stimulus plan looks like a massive extension of entitlements that amount to a redistribution of wealth, rather than real stimulus, and we doubt that infrastructure spending under the management of Congress will result in anything of productive use.

This week the markets will focus on an avalanche of corporate earnings releases and key economic data. Caterpillar started the week with a negative earnings surprise and the layoffs of 20,000 workers. On Friday, the government releases the first estimate of Gross Domestic Product for the fourth quarter of 2008. The consensus expectation is that the economy contracted at an annual rate of 5.5% (not a typo), indicating that the economy fell off a cliff in September.

Finally, we are watching action in the currency markets very closely for signs of what is called “competitive devaluation”. This refers to efforts by countries to devalue their currencies to protect their exports, a development that could have disastrous consequences for global growth. Last week, Swiss National Bank Vice President Philipp Hildebrand said, “In today’s environment, one could ask whether it wouldn’t be better to aim for a higher inflation rate in order to avoid deflation at any cost.” (emphasis added) Hildebrand also said the bank may “sell unlimited amounts of Swiss francs.” Statements such as this were behind the surge in the price of gold last week, and underscore our belief that central bank actions will eventually spark hyperinflation.


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