With earnings season upon us we are entering the heart of this recession, fourth quarter reports kicked off by Alcoa (AA) will show that weakness has spread to all sectors of the market, corporations will continue widespread layoffs, and housing will continue its plunge. Investors have anticipated this awful data for over a year now. Back on January 4, 2008 when the unemployment rate initially rose to 5% the Dow fell 257 points from 13,056 and the year long plummet down to 7,392 was all systems go. Markets do not react well to declining data points. Today the unemployment rate sits at 7.2% and is still decreasing at an increasing rate.
Housing isn't any better. We have an environment where record amounts of distressed sales are flooding the real estate market, lending is tight, and job losses threaten to further throttle prices downward. KB Homes (KBH) just announced that 4Q revenue ending November 30th fell to $919 million from $2.07 billion a year earlier. The latest results from the Case Shiller Home Price index showed a record year over year drop down to 18% in October.
Market optimists hang their hat on the fact that stocks typically recovery before the economy does. According to First Trust research conducted by chief economist Brian Wesbury, the market rises an average of 25% before the economy officially begins its recovery. His model shows the U.S. equity market is at its cheapest levels since 1953; eclipsing the levels of 1974, 1982, and 1994--all of which had huge bull markets ahead of them. In past articles, I have suggested that this phenomenon occurs because confidence is restored first. What will trigger the increased confidence this time around? I have 2 predictions:
1) Hank Paulson has been consistent in one thing and one thing only. I'll sum up his thinking with an excerpt from his NY Times Op-Ed piece, " I have always said that the decline in the housing market is at the root of the economic downturn and our financial market stress." A housing fix will trigger the beginnings of a recovery. Americans must feel that the ground beneath their feet is no longer sinking before they will commit their sideline cash back to the market. Last week Obama declared that he would unveil a housing plan in the next month or two. If the market likes this plan and reacts positively then you will know a recovery has been triggered.
2) The rate of unemployment declines must begin to slow. Once again, all eyes are on the government. Our current problems are beyond cyclical as they were caused by policy of greed and mismanagement. To solve the crisis we can manage our way out. Over the weekend Obama's economic team released an analysis that shows their plan of tax cuts and spending will create as many as 4.1 million new jobs. At the Economic Weather Station we are forecasting that the current tide of unemployment will continue to get much worse. However, Obama can change this momentum if he comes up with an infrastructure/alternative energy/tech plan that the people believe in. Once again, if the market likes the details and reacts positively you will know that a recovery has been triggered.
The simple conclusion comes from Pimco co-CEO Mohamed El-Erian when he provided insight into his 2009 projections during a recent interview on CNBC, "Pay particular attention to government action. The government, whether we like it or not, is going to be a major determinant of both relative and absolute value in '09. The government is going to be a major price-setter going forward."
I couldn't agree with him more. Investors know that historical data supports the idea that we are getting close to a stock market recovery but something has to trigger it. If the market likes the Obama housing and employment plans their success will soon follow. My money is with El-Erian, the trigger will be coming from Washington. These are two vital market variables to watch.