Today, the Dow Jones Industrials closed at 11,453.42. That is its lowest closing figure since the index closed at 11,396.84 on September 11, 2006. The Dow Jones Industrials is now 19.1% below its peak close of 14,164.53 on October 9, 2007. If one factors in inflation, the Dow is 22.4% below its peak. In fact, if one considers only inflation, inflation's bite would have been equivalent to a drop of some 585 points had stock prices held steady at the figure of the Dow's record close.

If one examines the experience from recent past recessions, the Dow could fall even farther from its present figure before it reaches its bottom.



Given the combination of rising inflation, energy price spike, and credit squeeze, a recession cannot be ruled out sometime from now through 2009. If anything, the Fed's failure to raise interest rates 25 basis points at the last meeting might well have planted the seeds for the need for much tougher monetary policy down the road. Should inflation expectations become unanchored--and the Conference Board's survey should consumers expect inflation to average 7.7% in the June 2008-2009 timeframe--inflation could become more embedded and persistent. Already, there is growing evidence of price pass-through. Then, much tighter monetary policy could be required to reel back inflation expectations and such monetary policy could exacerbate the strains facing what will likely remain a sluggish economy through much of next year.

Given past recessions and the ongoing dissipating housing bubble embedded in a larger inflationary environment, a decline to levels typical with recessions might well be a reasonable possibility before the stock market reaches its bottom. A 20%-30% decline from the October 9 peak would take the Dow Jones Industrials down to 9,915.17-11,331.62. Unless an actual recession unfolds, a bottom in the 10,750-11,250 vicinity might well be a realistic proposition.

There is no assurance that legislation aimed at curbing futures market activity would have such an impact on oil prices. There is even the risk that it could drain liquidity from the market leading to the kind of greater volatility and perhaps price stickiness that can be commonplace in illiquid or shallow markets.

The preliminary Commodity Futures Trading Commission (CFTC) findings did not find speculation as a driving force of the run-up in oil prices.



Notice that both net speculative positions and net swaps positions were essentially flat when the biggest run-up in crude oil prices commenced. Also, oil inventory statistics do not show a hoarding of crude oil. In fact, for the most part, such stocks have been gradually declining in recent months and are in or nearing the lower part of their historic range.

The CFTC is conducting further research at present and its next report will be published in September. Barring a change in what it finds, it is entirely possible that supply-demand and a depreciating U.S. dollar are responsible for the biggest part of the change in crude oil prices.

If so, addressing the demand imbalance (2006 and 2007 saw consumption exceed production) and stabilizing the U.S. dollar would probably afford a much better chance at bringing about a decline in crude oil prices. To stabilize the dollar, one would need a continued significant contraction in the trade deficit (unfortunately, crude oil imports impede how far the deficit can decline), fiscal restraint (not likely), coordinated Treasury-international intervention in the foreign exchange market (opposed by the U.S.), or a hike in interest rates (questionable in the near-term even as inflation and inflation expectations mount, in part on account of crude oil prices that a stronger U.S. dollar would temper).

Until energy prices and inflation are addressed, corporate profits may well be squeezed further. Such a development could limit the potential for sustained robust stock market rallies. Should inflation continue to escalate, it is not implausible that an extended period of negative after-tax returns could occur. For example, during the inflationary 1973-81 period, the S&P 500 Index rose 20.0% from 102.09 to 122.55. However, consumer prices more than doubled during that period. As a result, the after-inflation return on the S&P 500 Index was -54.3%.

Finally, on the political front, should investors also begin to conclude a significant capital gains tax hike is possible, that might also inhibit their willingness to purchase securities.