Has the Fed redeemed itself?

So this may be a throw worth making. Let's take a look at the potential.

The bulls believe relatively prompt government action on tax rebates and deep interest-rate cuts have provided the opportunity for a shallow and short recession, with the fourth quarter of last year clocking in with a slight contraction in U.S. economic growth, followed by about a 1% contraction in the current quarter and then back to a fractional decline in the second quarter and on to a tepid recovery in the third quarter.

Keys to the bulls' positive attitude is the tidal wave of money that the Federal Reserve has resolved to pour into the financial system. Short-term interest rates will enter the second quarter in a week at 2.25% and will likely fall to 2% or 1.75% by the end of May. The Fed's new bank- and brokerage-financing operations will also be in place with alphabet-soup names such as TAF, TSLF and PDCF (don't bother learning what they mean), which are aimed at transforming distressed asset-backed securities into shiny new bundles of cash that can be lent out.

The Fed in recent years has drawn a barrage of criticism -- for being too slow to pop the tech stock and housing bubbles, and for being too much of a Wall Street lap dog -- but Bernanke's creativity in preventing a Bear Stearns-ignited meltdown is winning him some well-deserved praise.

This rescue effort was preceded by an increase in the money supply of $204 billion, equating to a 12% annual growth rate. And on top of that, the government has decided to allow mortgage guarantors Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) to make bigger loans for more-expensive houses at time when home loan rates are coming down.

Global gluttons unleashed

There are lots of other boosts for the economy dead ahead: Tax rebates are expected to start hitting mailboxes in early May, and many states will complement those with sales-tax holidays. Auto incentives are expanding from generous to ridiculous, and lower interest rates are finally sinking in to encourage more refinancing.

On the corporate side of the ledger, we see that earnings estimates outside the financial industry are expected to clock in at 13% for the first quarter, and layoff announcements are coming in at only about 5,700 per week, a far cry from the 42,000 per week seen during the last recession. Meanwhile, stronger industrial metal and energy prices suggest that Chinese and Indian growth has not broken down as many expected, which helps the earnings of major U.S. exporters such as Caterpillar (CAT, news, msgs) and General Electric (GE, news, msgs).

We can tell there's no lack of funds to buy stocks, if the mood catches fire, from the "global glut of savings" that Bernanke likes to cite. Just look at the $18 billion initial public offering of Visa this month, the $14 billion acquisition budget set by Aluminum Corporation of China (ACH, news, msgs) last week and a recent wireless-spectrum auction that topped $19 billion. Elsewhere, Indian automaker Tata (TTM, news, msgs) has raised $3 billion to buy Jaguar and Land Rover, and International Paper (IP, news, msgs) just offered $6 billion for some Weyerhaeuser units.

In this context, institutional investors are ready to look ahead by six to nine months and don't seem to care whether the U.S. economy troughs at negative 1% or negative 2%. They are already on to considering how strong the recovery will be, its sustainability and which sectors will lead. They're not expecting the economy to be all better soon; they just think that most of the bad news has already been priced in.

Francois Trahan, a portfolio strategist at ISI Group in New York, points out that the leadership of industrial transportation providers and retailers at this stage of a recession can be perplexing because the stocks start to move higher even though company fundamentals appear terrible. Specifically, he says, they typically find footing just as it become apparent that payroll growth and consumption are slowing and business- and consumer-loan growth have peaked. In other words, they do best when the economy is at its worst.

The same scenario played out in the last two major slowdowns, in 2001 and 1991, and anyone who waited for fundamentals such as job growth or spending to recover missed a big advance. The bottom line is that regardless of what we may think of the present, institutional investors have collectively decided that the Fed's plan is going to work, that banking losses will be socialized and that it's time to discount the prospects for sharp improvements in the economy in 2009.

Technicians suggest bearish sentiment could well confine the major indexes to a wide trading range through autumn, with the S&P 500's top at 1,525 and its bottom at 1,275, but industries unhampered by tight credit and consumer edginess could break out. If credit loosens up, the risks, for once, could actually be on the upside.

Fine print

To learn more about the Federal Reserve, click here. To learn about Tim Geithner, who some call the brains of the operation now, click here.

Bear Stearns, of all sources, has a great research piece on its Web site about the excellent prospects for transportation stocks in 2008. See it here.

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At the time of publication, Jon Markman owned shares of CSX.

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