While it’s not the Great Depression, we do think there will be a whiff of deflation over the coming few quarters. Recall, however, what Chairman Bernanke said in his 2002 speech about fighting deflation, as reprised by Merrill Lynch:

“Checking against Chairman Bernanke’s playbook for dealing with deflation we see that in 2002 he noted that the Fed could 1) target long-term yields, 2) purchase Agency debt, 3) offer direct loans to banks using a wide range of collateral, 4) purchase foreign bonds and municipals and, as a last resort, 5) use foreign exchange rates. Given that he has done numbers 2 and 3 and that 5 would not seem to be helpful in the current environment, it is important to consider the possibility that the Fed might choose to explore, as he put it, ‘A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceiling for yields on longer-maturity Treasury debt.’”

Plainly, Ben Bernanke is using, and/or considering, all the tools in his “toolbox” to dissuade the economy from plunging into a deflationary depression. Still, it appears that a pretty severe recession is in the works with 4Q08 GDP tracking toward a negative 5% reading. GDP is unlikely to turn positive before the second half of 2009.

Adding to the deflationary and recessionary environment, consumer prices (CPI) registered their largest monthly decline in the 61-year history of the data; ditto the PPI; unemployment claims leaped to their highest level since 2001; housing starts sank to their lowest level ever; permits for new houses tumbled to their lowest level ever; and the LEI (Leading Economic Indicators) slid 0.8% in October.

All of these indicators are setting the stage for an abysmal holiday selling season, telegraphed by last week’s -4.1% (year/year) collapse in nominal retail sales. In fact, according to Ed Hyman’s ISI organization:

“The single best correlation for holiday sales has been the stock market in the months leading up to the Christmas season with a 61% correlation. With the severe global recession, intense competition, and the halving of commodity prices already, we are probably entering a period of deflation. This is setting up the weakest NOMINAL GDP since 1954, something we worry the country’s business isn’t prepared for.”

Meanwhile, the dour economic backdrop has caused analysts to lower their earnings forecasts on companies to the point whereby only 222 companies in the S&P 1500 have seen their earnings estimates increased.

Obviously, this decline in earnings expectations has a caused a recalibration of P/E multiples with an attendant “hit” to stock prices. And last week that “hit” caused the S&P 500 to fall to its lowest closing level since April 1997, while other US indexes set 5½-year lows. Moreover, the Wilshire 5000 index, the broadest measure of the US markets, has now fallen by more than 50% since its peak 13 months ago. Treasury yields also fell to record lows with the 30-year US Treasury bond declining to lows last seen in the early 1960s.