Mustard Seeds #1 and #2

Everyone on Wall Street and in the stock market remains highly fearful of banks and the credit crunch, which of course extends to the mortgage-credit and foreclosure problem. Fear is certainly trumping some very attractive fundamental valuations that may turn out to be a once-in-a-generation buying opportunity for stocks.

But there’s another crucial aspect to this story: A terrible oil shock and gasoline-price spike decimated the economy this year (actually beginning in the last quarter of 2007), with the onset of an energy bubble driving up oil prices from roughly $75 a barrel to nearly $150 and the retail gas price from $2 to more than $4. It’s one of the most underrated causes of the recession and the plunge in corporate profits that spilled over into share prices.

In fact, since the early 1970s, we’ve had six recessions. And every one of them was preceded by an oil shock. Plus, the Federal Reserve response to stop inflation has always dealt the economy a rough hand of very tight money on top of very high energy prices.

The oil shock of the past year surely has made the credit crunch much worse than would otherwise have been the case. The soaring energy costs killed consumer spending — including servicing mortgages. And that in turn made the mortgage-backed paper owned by banks much less credit worthy and much more damaging to their earnings and their balance sheets.

Yet now, as people are looking for a way out of the terrible stock market recession, the Fed’s tight-money policy plus the very big oil shock — a huge tax hike on the economy — are completely reversing. Notice the two charts below:

As Carpe Diem blogger Professor Mark Perry points out, the real price of gas has utterly collapsed. He believes this amounts to a $300 billion tax cut to bolster consumer purchasing power. That’s mustard seed #1 for a bull-market recovery.

But mustard seed #2 is a radical change in Fed policy. Notice the chart on the monetary base, which is a proxy for the Fed’s balance sheet. It was essentially flat in 2006, 2007, and the first half of 2008. The yield curve in the Treasury securities market was inverted — that is, upside down, with short rates higher than long rates — for about two and half years, another sign of very tight money. But in the last three or four months all this has changed. The Fed is pouring new cash into the financial system. The Treasury curve is positively sloped.

So what we have now is energy tax cuts and a very easy Fed. It’s the exact reverse of energy tax hikes and a very tight Fed. Obviously, this new easy-money/tax-cut mix is pro-recovery. And that’s why I think people are altogether too gloomy about next year’s economy and the stock market.