The economy is bottoming

The U.S. and world economy were in free-fall in the latter months of 2008. Panic reigned. Investors and speculators were selling anything and everything in order to raise cash and/or pay down debt; yields on cash and Treasury bonds collapsed as a result of intense demand for risk-free assets. All the things that had shot up in price in the past several years (e.g., gold, commodities, energy prices, real estate) suffered sudden and massive price declines as investors and speculators scrambled to reverse the trades that had been so profitable up until mid-2008. Equities collapsed as well, as everyone feared that massive wealth losses would result in equally massive unemployment, a depression of epic proportions, and widespread price deflation.

Equities experienced another vertiginous drop in January and February of this year as investors were blindsided by the Obama administration's rush to implement an unprecedented expansion of government spending, a radical increase in the price of carbon-based fuels, a significant increase in overall tax burdens and in the tax on capital, and a major push to advance universal healthcare. All of this on top of what looked like complete disregard for federal deficits that could be measured in the trillions of dollars for many years to come. Not surprisingly, many thought that we were experiencing the end of the world as we knew it.

Over the past month, however, the doom and gloom has faded somewhat. Equities have recovered most of this year's losses. Obama's plans have been dealt several blows: the Senate has rejected his proposal to limit the charitable deductions of the rich; cap and trade will not be imposed on the country without a thorough debate. Obama's popularity has taken a hit, and many of his formerly ardent supporters now question the wisdom of his decisions (e.g., allowing Nancy Pelosi and Harry Reid to design his stimulus plan, firing the CEO of GM and dictating which car models the company should focus on). Mark-to-market rules have been relaxed. As the first chart shows, interest rates on Treasury bonds have risen almost one percentage point from their year-end lows. As the second chart shows, oil prices are up 50% from their December lows; most commodity prices are higher today than they were at the end of the year. Both charts provide strong evidence that the economy is not collapsing as many had feared, and may even be finding a bottom.

This is not to say that the economy is now off to the races. The good news that has driven stocks higher is that the bad news that had been expected has failed to materialize; things aren't as bad as the market had feared.