OPINION
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August 31, 2012, 6:42 p.m. ET
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The Federal Reserve: From Central Bank to Central Planner
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The Fed's 'nontraditional' actions have crossed a bright line into fiscal policy and the direct allocation of credit.
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By JOHN H. COCHRANE

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            Corbis





Momentous changes are under way in what central banks are and what they do. We are used to thinking that central banks' main task is to guide the economy by setting interest rates. Central banks' main tools used to be "open-market" operations, i.e. purchasing short-term Treasury debt, and short-term lending to banks.




Since the 2008 financial crisis, however, the Federal Reserve has intervened in a wide variety of markets, including commercial paper, mortgages and long-term Treasury debt. At the height of the crisis, the Fed lent directly to teetering nonbank institutions, such as insurance giant AIG, and participated in several shotgun marriages, most notably between Bank of America and Merrill Lynch.


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These "nontraditional" interventions are not going away anytime soon. Many Fed officials, including Fed Chairman Ben Bernanke, see "credit constraints" and "segmented markets" throughout the economy, which the Fed's standard tools don't address.



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Moreover, interest rates near zero have rendered those tools nearly powerless, so the Fed will naturally search for bigger guns. In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that "we should not rule out the further use of such [nontraditional] policies if economic conditions warrant."


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But the Fed has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed's independence, allowing it to do one thingconduct monetary policy—without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.



In addition, the Fed is now a gargantuan financial regulator. Its inspectors examine too-big-to-fail banks, come up with creative "stress tests" for them to pass, and haggle over thousands of pages of regulation. When we think of the Fed 10 years from now, on current trends, we're likely to think of it as financial czar first, with monetary policy the boring backwater.



A revealing example of where we are going emerged last spring, admirably documented on the Fed's website. Using its bank-regulation authority, the Fed declared that the banks that had robo-signed foreclosure documents were guilty of "unsafe and unsound processes and practices"—though robo-signing has nothing to do with the banks taking too much risk.



The Fed then commanded that the banks provide $25 billion in "mortgage relief," a simple transfer from bank shareholders to mortgage borrowers—though none of these borrowers was a victim of robo-signing.




The Fed even commanded that the banks give money to "nonprofit housing counseling organizations, approved by the U.S. Department of Housing and Urban Development." Why? Many at the Fed see mortgage write-downs as an effective tool to stimulate the economy. The Fed simply used its regulatory power to help meet that policy goal.



Even if you think it's a good idea (I don't), a forced transfer from shareholders to borrowers in pursuit of economic policy is the province of the executive branch and Congress, subject to reproof from angry voters if it's a bad idea.




The Fed said candidly that it was acting "in conjunction" with the state attorneys general and the Justice Department. So much for an apolitical, independent Fed.



True, $25 billion is couch change in today's Washington. But you can see where we are going: Hey, nice bank you've got there. It would be a shame if the Consumer Financial Protection Bureau decided your credit cards were "abusive," or if tomorrow's "stress test" didn't look so good for you. You know, we've really hoped you would lend more to support construction in the depressed parts of your home state.




Conversely, when the time comes to raise interest rates, how can the Fed not consider that doing so will hurt the profits of the too-big-to-fail banks now under its protection?




This is not a criticism of personalities. It is the inevitable result of investing vast discretionary power in a single institution, expecting it to guide the economy, determine the price level, regulate banks and direct the financial system.



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Of course it will use its regulatory power to advance policy goals. Of course, propping up the financial system will affect monetary policy. If we don't like this sort of outcome, we have to break up the Fed into smaller agencies with narrowly defined mandates.




The European Central Bank's political power is, paradoxically, even greater. The ECB was set up to do less—price stability is its only mandate, and it is not a financial regulator. But the ECB holds the key to the euro-zone's central fiscal-policy question. It has bought the debts of Greece, Italy, Spain and Portugal, and it is lending hundreds of billions of euros to banks, which in turn buy more of those sovereign debts.


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Eventually, the ECB will have to suck up this volcano of euros, by selling back the bonds it has accumulated. If it can't—if the bonds have defaulted, or if selling them will drive up interest rates more than the ECB wishes to accept—then the ECB will need massive funds from German taxpayers to prevent a large euro inflation. It might ask for a gift of German bonds it can sell, as "recapitalization," or it might ask for a bond swap of salable German bonds for unsalable southern bonds. Either way, German taxes end up soaking up excess euros.



Our views of central banks have changed every generation or so for centuries. The idea that central banks are centrally responsible for inflation and macroeconomic stability only dates from Milton Friedman's work in the 1960s. It's happening again, and it would be better to think clearly about what we want central banks to do ahead of time.



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Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at the Hoover Institution, and an adjunct scholar at the Cato Institute.



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Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved



The Roots of Chile’s Malaise

Andres Velasco

31 August 2012
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SANTIAGOMargaret Thatcher famously once said that “there is no such thing as society.” Today, the people of Chile are showing just how wrong she was.

 
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For more than a year, young Chileans have been taking to the streets to protest. Many foreign observers have declared themselves surprised. Why would the citizens of a successful emerging country be so upset? What could they be upset about?

 
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Chile’s student-led protest movement has generated much re-thinking within the country. Intellectuals of the old left, pointing to persistently high income inequality, have argued that the economic gains made in the 22 years since the return of democracy were more illusory than real. In this view, Chile’s economic model has failed its citizens and is in the process of “collapsing.”

 
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Defenders of Chile’s current rightist government, pointing to ongoing economic growth and unemployment under 7%, have argued that there is no deep reason for discontent. In this view, if the government stays the course and the economy keeps growing, the malaise will pass.

 

Recent survey data and a detailed study by the United Nations Development Program (UNDP) suggest that both of these oversimplified views are mistaken.

 
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In public-opinion polls, Chileans declare themselves to be quite happy, and say that they live much better now than they did a decade or a generation ago. They also overwhelmingly claim that education and hard work are the ways to get ahead in life. And many poorer citizens report growing satisfaction with the health care and pensions to which they have access. This is hardly the stuff of a country whose development model is on the verge of “collapse.”

 
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But, while Chileans are quite happy with their own lives, they are upset with the society in which they live. Respondents report that they are increasingly resentful of economic inequality and social segregation. They do not trust politicians and political parties, judges, captains of industry, or even members of the clergy.


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Many Chilean parents send their children to private schools, but polls report a growing demand for better public schools, which they value as a place where common values are forged among children of different backgrounds. Many are happy about growing home ownership, but are unhappy about the scarcity of public spacessafe streets, parks, arts facilities, and community centers – where they can come into contact with their fellow citizens.


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This is where Thatcher’s famous statement has proven to be so wrong: there is such a thing as society, and the quality of interactions within it matter profoundly for people’s satisfaction with their lives.


 
Uncertainty and fear are two reasons why many middle-class Chileans report being unhappy about their society. Making it into the middle class requires decades of hard work, but it can all come to naught as a result of an accident, an illness in the family, or the loss of a job. Chile’s social insurance system, these citizens are saying, is insufficiently social and does not provide enough insurance.


 
The other key source of malaise, the UNDP study reports, is the persistence of discrimination and mistreatment. Too many people report being mistreated on account of their gender, race, socioeconomic status, and even physical appearance.


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Discrimination in the labor market is widespread. Plum jobs, middle-class citizens report, seem to be set aside for people with certain last names, from certain neighborhoods, or from certain schools.
 
 
 
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So the issue is not that people are turning against a system that promises a better life for those willing to work hard and get a better education. Far from it. People are upset that – because of prejudice and abuse – the system is failing to deliver what it promises, even to people with many years of schooling who exert themselves day in and day out
 


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This much is clear to those of us who are listening to what the citizens of Chile are saying. Traditional Chilean politicians, however, do not seem to be doing much listening. Their infighting continues to upset people, while most of their policy proposals have little to do with the problems that ordinary citizens face. For the sake of Chile’s future, that will have to change.


 
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Andrés Velasco was Chile’s finance minister from 2006 to 2010, earning praise for innovative policies that included a measure to save Chile’s copper windfall in a rainy-day fund. At the forefront of Latin America’s economic transformation as both an academic and a policymaker, he served as chief negotiator for Chile’s participation in NAFTA in the 1990’s, and has consulted for the International Monetary Fund, the World Bank, the Inter-American Bank, and several Latin American governments. 


Barron's Cover
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SATURDAY, SEPTEMBER 1, 2012
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Tough as Teflon
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By VITO J. RACANELLI
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The stock market has deflected lots of worrisome news this summer, and Wall Street strategists see more gains ahead. Beware the fiscal cliff.
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     Scott Pollack for Barron's







Call the stock market's swift 10% rise since the end of May a Teflon rally of sorts, because myriad worries on Wall Street -- from the so-called fiscal cliff in the U.S. to Europe's financial mess to turmoil in the Mideast -- haven't stuck, much less slowed the bull's progress. Instead, stocks have marched gamely higher, as ultra-low interest rates have burnished risk assets' attraction and propelled investors to seek higher returns.



The market's spirited advance not only has delighted investors, but vindicated the mostly bullish 2012 forecasts of 10 prominent market strategists Barron's surveyed last December. The Standard & Poor's 500 is up 12% year-to-date, to 1406, and most of these seers still are bullish, even though stocks are more expensive now, and worries about the economic backdrop remain.


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The mean year-end S&P forecast of the group's seven optimists is 1446, which suggests stocks will rise 15% for the full year. John Praveen of Prudential leads the pack, with an S&P price target of 1480.



The bears, though fewer in number, also are filled with conviction. Barclays' Barry Knapp sees the S&P falling to 1330 by year end, while David Kostin of Goldman Sachs pegs fair value at 1250. Adam Parker of Morgan Stanley is the group's ursa major, with a price target of 1167, based in part on his prediction that corporate profits will decline in 2013.
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In general, the strategists agree on the potential pitfalls to higher investment returns: The global economy is sluggish, corporate earnings have high hurdles to leap, and the U.S. faces a fiscal cliff, or automatic tax hikes and spending cuts at year end, unless Congress moves decisively to undo one or both. But the bulls and bears are strongly at odds on how these problems will play out in coming months.



Wall Street's bullish strategists say the summer rally is evidence of the market's fortitude in the face of well-known concerns. After the presidential and congressional elections are decided in early November, they argue, Washington's heretofore warring parties are likely to reach some sort of agreement on how to forestall fiscal Armageddon by raising some taxes and paring some mandated cuts. As for Europe's troubles, they argue, investors have grown accustomed to living with the uncertainty overseas.



Although most bulls see only small gains for corporate profits, they note that the market's valuation isn't demanding by historical standards, and especially in comparison with low bond yields. The S&P 500 trades for 13.7 times strategists' 2012 profit forecast and 13.1 times their early consensus estimate for 2013. The prevailing bet: Stocks will continue to rise with little fanfare, as has been the case for much of this year.



Not so fast, the bears reply, pointing to stocks' swoon in May, and a rout last August when Congress struggled to reach agreement about raising the U.S. debt ceiling. All it would take, they say, is one serious setback, particularly a failure to legislate an end to the fiscal cliff or a banking crisis in Europe, to send the market reeling by year end.



Here's a closer look at how Wall Street's strategists see some key investment themes playing out in coming months.
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Corporate Profits and Equity Sectors

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With 2012 two-thirds done, the pros see S&P 500 companies earning $100 to $105 this year. Based on the midpoint of that range, profits are expected to rise 5% from last year's $97.82. The "top-down" crowd isn't far off from its "bottom-up" counterparts, or industry analysts, who are forecasting corporate profits of $103.39 for the year.


 
image





Our 10 strategists' mean profit prediction for 2013 is $107.37, implying another 5% increase. But there is a wide gap in their profit targets, from $98.70 at the low end to $110 at the top.



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Analysts have a rosier view, as is common, and see S&P earnings hitting $115.46 in 2013, up 12% from this year's estimate. The bullish strategists expect an expansion in the market's price/earnings multiple, not growth in earnings, to be key to any future rally.


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Among stock sectors, technology is favored by most of the bulls in our group, who urge an avoidance of materials and utilities shares. Tech has some of the most visible earnings growth in the market, which has helped push up the S&P 500 technology sector 19% this year. Materials, on the other hand, have suffered from declining commodities prices; the shares are up 6.2% in 2012. Utilities offer little profit growth, but owing to dividends have returned a total 3.1% this year.




Like many market watchers, the strategists are bearish on U.S. government bonds, and have been since last year. That has been a frustrating bet so far, as a big drop in bond prices has yet to materialize.




Health care and energy are top picks among the Street's skeptical strategists, the former for its relatively stable earnings growth. Health-care stocks are up 16%, year-to-date, well ahead of the energy sector's 3% gain. The strategists generally dislike consumer-discretionary shares, which have rallied about 16%. The sector could be vulnerable if the economy slows and the stock market falls.
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Political Risk



With Democrats and the GOP running neck and neck at the polls, political risk is this year's big wild card for the financial markets. Unless Congress and the president strike a deal on taxes and spending, the Bush administration's payroll tax cuts and reduced tax rates on capital gains and dividends will expire automatically at the end of 2012.



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Jobless benefits also will be cut, and more than $1 trillion used to fund the federal government will be sequestered. Together, these outcomes constitute the fiscal cliff, and going over it would damage the economy, at least in the short-to-intermediate term.



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If the scheduled policy changes take effect at year end without subsequent alteration, Goldman Sachs economists figure that gross domestic product, adjusted for inflation, will be nearly four percentage points lower by the end of 2013 than if fiscal policy had remained constant. Specifically, GDP would contract by 0.4%, pushing the economy into recession.



"The fiscal cliff is tough to call," says Stephen Auth, chief investment officer of Federated Investors; he has a year-end S&P target of 1450. "The way the elections turn out will mean much."


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Those bullish on stocks generally say that a Republican sweep of the White House and both houses of Congress would be the best outcome for policy and the markets. A victory by President Obama, but a vote that puts Republicans in control of Congress could be trickier. Both sides could "play chicken" on the fiscal cliff, and that's "not a good outcome," Auth says. He believes both parties eventually will come to an agreement, perhaps to extend the Bush tax cuts for a year.



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Goldman's Kostin offers a gloomier assessment. While many investors believe that Congress will do something, says Kostin, "the political realities are that there's not too much willingness to compromise."


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Both parties played a good game of chicken last August over lifting the U.S. debt ceiling, only to agree to a deal at the 11th hour. But the market fell sharply while the negotiations dragged on, and Standard & Poor's lowered Uncle Sam's vaunted triple-A debt rating.



Investors have taken a seemingly benign view of the fiscal cliff, "but this is a meaningful risk not discounted by the market," Kostin says. "A compromise [by a lame-duck Congress] might not happen by January."


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Even the optimists are worried. Congress might vote to allow some fiscal contraction, says Jeffrey Knight, head of global asset allocation for Putnam Investments, but the fear is that legislative measures will allow for more contraction than the market currently expects. Knight has a 1420 S&P target, and a small overweighting in U.S. large-cap technology and industrial stocks, and emerging-market shares. If the "risk-on" trade continues, lagging emerging-market shares could rally more, he says.
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Strategic Picks

 
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Most Wall Street strategists make big-picture calls, but some also pick stocks. Technology, health-care and energy shares are among their current favorites. Dividends are a big attraction to the pros.




Company/Ticker Recent Price 12-Mo
Chg
P/E
'13E
Comment
STEPHEN AUTH, Federated Investors
Caterpillar/CAT$84.47-6.0%8.0Cheap, due to catch up
Qualcomm/QCOM 61.2019.415.0 A winner in the Apple/Samsung battle
Daimler/DDAIF48.85-7.36.7Luxury-goods company disguised as auto maker
ROBERT DOLL, BlackRock
Chevron/CVX110.9312.78.9 Good fundamentals and cash flow; cheap shares
ConocoPhillips/COP56.118.59.9Lean and mean, prepared to do better
UnitedHealth Group/UNH54.6915.79.8 Largest U.S. health-insurance provider
ADAM PARKER, Morgan Stanley*
Chevron/CVX110.9312.78.9Discounts low oil prices; safe yield
Bristol Myers Squibb/BMY32.8712.917.7Safe yield and achievable earnings estimates
AmerisourceBergen/ABC38.10-3.012.1High shareholder return; growth at a good price
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E=Estimate. *Three of 50 stocks in strategic portfolio based on Parker's quantitative stock-selection model. Source: Bloomberg

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Trouble in Europe
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Who's afraid of the Continent's sovereign-debt crisis? The bickering and bargaining among euro-zone leaders to save the European Union's most profligate countries from default has dragged on for more than two years. Yet a resolution still appears a long way off.



While U.S. investors are growing accustomed to the ups and downs of the negotiations, "the days Europe is on the front page generally aren't good for the market," says Robert Doll, a senior advisor at BlackRock. "I'm most afraid of Europe. I can live with the elections and fiscal cliff, but I fear a sort of break that leads to a European banking crisis that affects the rest of the world."



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Doll doesn't think that will happen this year, however, based on his year-end S&P 500 forecast of 1425.


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Other bearish strategists believe that investors are underestimating the depth of Europe's financial woes. "The problems in Europe aren't close to a solution," says Barclays' Knapp. He notes that European labor costs aren't competitive globally, and that value-added taxes are rising across the Continent to combat the fiscal imbalances.



Yet, bulls expect the Europeans eventually to come to some sort of messy compromise, and to become less of a concern for the markets. "We don't need to fix the European problem for markets to rally," says Thomas Lee, the chief U.S. equity strategist at JPMorgan Chase. "We only need it to stabilize." Lee expects the S&P to end the year around 1475.




What's Next?

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Our pundits agree that corporate profits will grow at a slower pace this year than last, but differ as to whether the market is cheap or expensive, and on what will propel stock prices from here.


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Lee acknowledges that analysts' consensus earnings estimates have fallen lately, but he expects U.S. housing activity to quicken and construction to "take up the slack." In a recent CIA ranking of construction spending, he says, the U.S. stood at No. 142, behind Zimbabwe, Nigeria, and El Salvador, among others.



"It can't continue like that," says Lee, who forecasts $110 in S&P earnings next year. "Either stocks get more expensive or everything else falls."



Citigroup's head of U.S. equity strategy, Tobias Levkovich, likes to cite data from the Federal Reserve survey of senior loan officers, which looks at credit conditions, among other things. It consistently leads economic activity by about nine months, he observes. It fell last October but has risen in the latest three quarters, "signaling we will have growth," says Levkovich. He expects the market to close at 1425 this year, and stocks to earn $108 in 2013.



Auth, of Federated, sees the S&P 500 at 1600 in 12 to 18 months, and says a price/earnings multiple of 17 is "more normal" in a period of abnormally low interest rates. But he expects the market to trade for 15 times future earnings at this point next year, assuming U.S. and European policy makers don't behave irrationally. On the bright side, he says, "regardless of who is elected president, we've seen the high point of repression of the private economy, and that's worth a couple of multiple points."



The bears see it otherwise. Decelerating earnings growth, fiscal uncertainty, and artificially low interest rates make for a multiple-contracting environment, says Knapp, who argues that more normal rates would promote a higher P/E. The sooner the Federal Reserve raises rates, he asserts, "the closer we are to a sustainable market rally."



Morgan Stanley's Parker also contends that an extreme rate level is bad for P/E multiples. He sees minimal profit growth, in addition to a big retreat in the S&P.


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Timing is everything in market calls, along with price. Hence, this caveat from both our bulls and bears: With the elections looming and potentially critical policy changes to come, their forecasts won't play out until the end of 2012, and probably not before the polls close on Nov. 6.


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That could mean more time for the Teflon bull to strut his stuff, and for Mr. Market to disregard bad news.


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Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved