The following is a reprint of the market commentary from the December edition of the Option Advisor, published on November 15. Prices and the chart are as of the close on November 15. For more information or to subscribe to the Option Advisor, click here.

The accompanying chart produced by Alan White of our quantitative analysis group shows the price action of the S&P 500 Index (SPX) during the past 25 years. But of even greater interest are the darkened sections of this chart, which demarcate those periods during which the Fed Funds target rate was below the 10-year yield. While I'm over simplifying a bit, we can express these darkened segments of the chart as periods during which the yield curve was inverted.

Traditional economic analysis points to an inverted yield curve as signaling economic weakness ahead, as investors are anticipating that reduced economic activity in the future will cause interest rates to decline below their current levels. Another way of describing this situation is that Fed policy is too tight, and that the economy will pay the price for this. But this recession indicator is by no means infallible, and you will note from the accompanying table that Fed Funds - 10-year relationship has been inverted for 529 days and counting, the longest of any of the periods studied on the chart, and we have been "recession-free" throughout this time frame. And of even greater importance to investors, the SPX has managed a decent positive return over this period. In fact, the SPX had positive returns for 3 of the 4 periods of curve inversion depicted on the chart.

This situation has confounded many analysts who have been forecasting slower economic activity on the basis of the inverted yield curve. And many have scoffed that the inverted yield curve has predicted "5 out of the past 3 recessions." While I'm not in the business of forecasting the economy, I do feel the risks are elevated as long as the curve remains inverted, and I do feel it is imperative that the Fed continues to cut rates - the sooner and more aggressively, the better. Note from the table that while the period of inversion from April 2000 to April 2001 was accompanied by a 24% decline in the SPX, the ultimate decline by the SPX into the October 2002 bottom was about 50%. As I see it, this was because the Fed got too far "behind the curve," and their lack of aggressiveness resulted in negative economic momentum that continued even as the Fed began easing aggressively.

I continue to be amazed at the arguments put forth by those who oppose Fed rate cuts, even as they acknowledge the risks to the economy emanating from such factors as the credit crisis, the housing market implosion, and higher energy prices. Many of these arguments center on the alleged fact that rate cuts will not help the housing market because the crisis is emanating from credit quality issues. But a sharp reduction in the interest rates underlying the upcoming mortgage rate resets would, in fact, be immensely helpful. Inflation worries are cited by others and "bailing out Wall Street" is also a common objection to rate cuts. But I believe the risk that the economy will contract to such a point that it can't easily be revived will begin to take precedence at the Fed.

The good news right now as compared to early 2000 is stock valuations are much more modest than they were at the bubble peak, and the market is far less technically overextended relative to its long-term moving averages. Also, investor sentiment is far more muted now, and there is a much more active contingent of short sellers who will provide buying support on pullbacks. This suggests that the market could absorb a modest slowdown in economic activity without falling out of bed, and further upside is quite possible under this scenario. But a major recession would likely be quite another story, and the Fed needs to get busy. Now would not be a moment too soon.

Copyright Schaeffer's Investment Research http://www.schaeffersresearch.com

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