Market, Economy Downward Spiral Has Been Broken

We have been on record for the past month with the view that a major market bottom was made in early March, when fears of financial and economic Armageddon peaked. The technical market action over the course of the past two months’ rally is much more characteristic of a sustainable new uptrend than a short-lived bear market reprieve. The downward spiral in the economy and markets has been broken (regrettably at the cost of a massive extension of government credit and obligations).

Leading economic indicators and consumer confidence readings have improved to a degree that indicates the worst of the economic downturn is behind us. Consequently, investors have begun the process of moving away from the heavily defensive posture of two months ago. We have seen a broad-based rally in risk assets, and a simultaneous retreat from “safe havens” such as Treasuries, cash, and gold. Emerging markets stocks surged 17% in April, the best monthly gain in 20 years, and high-yield corporate bonds returned 11% in April, the best monthly performance for that asset class in its history.

Short-term, risk assets are overbought. The S&P 500 has gained 30% off the March 9 bottom, and has not suffered more than a two-day pullback over this period. “Higher beta” equity indexes have run up even more: MSCI’s U.S. extended markets (small and mid cap stocks) and emerging markets indexes have gained approximately 40% from their lows. A period of correction or consolidation could begin at any time, but if a durable rally phase has indeed begun, which we suspect is the case, pullbacks on the S&P 500 will be limited to no more than 10%, and probably closer to 5%.

Looking out over the balance of the year, the risk/reward in stocks still appears favorable. Although the bullish camp is gaining more adherents, there is still ample skepticism for risk assets to climb the “wall of worry,” which is so typical following a major bear market low. There is a bearish argument that any significant rise in prices will be met with selling from investors seeking to recoup earlier losses, or a move to the safety of cash until they can “figure out” this confounding investment environment. But that hasn’t happened - at least not yet. The stock market has held up extremely well in spite of overbought conditions. Instead, there seems to be a bullish “selling vacuum” at work. The chart below suggests that at the depths of first quarter lows, U.S. households collectively had already moved into such a defensive position with respect to their stock allocations that selling pressure literally dried up.

Despite a strong initial rally from the March 9 low, stocks remain near the bottom of their tenyear range. From its present level, the S&P 500 would need to gain 10% per annum for six years to return to the peak levels reached in 2007 and 2000 peaks.

S&P 500 10-Year Nominal Price Performance [click to enlarge images]

The loss of value in the stock market this decade is even more dramatic when adjusted for inflation. When inflation (measured by the CPI) is applied to historical stock values, which is what is done in the chart below, the S&P 500 is currently 55% below the inflationadjusted stock market peak in March 2000.

S&P 500 10-Year Inflation-Adjusted Performance

Comments

[Sutida:]

Like many others I remain hopeful that the worse has past, however I do feel the DOW could pull back to the 7500 level. Should it do so, this would represent an excellent buying opportunity for companies that have survived the crisis without too much damage.

May 04 08:50 AM

[Dave Wrixon:]

The Dow could still go below 5000 or even much lower.

This recovery is largely based on largess and deceit by Government.

That will not produce a sustainable rally. When the Pollyanna's realize the man giving them lovely candies just wants to shag them, then watch the panic set in.

May 04 09:52 AM

[The Geoffster:]

Yeah, but the Cetin Rally continues....

May 04 10:01 AM

[whidbey:]

"A period of correction or consolidation could begin at any time, but if a durable rally phase has indeed begun, which we suspect is the case, pullbacks on the S&P 500 will be limited to no more than 10%, and probably closer to 5%."

If your guess is correct it is just the prelude to the further expansion of the public debt now totaling 94 Trillion. This will do what debt did in the fall of 2008, pressure the stocks - not all- but most down again.

May 04 10:12 AM

[conceptwizard:]

Nice piece that supports the rally. There is simply to much offsetting information that would crush the optimism here. These extremely negative indicaters would see consistant signs of improvement before a sustained rally can be reached. Otherwise this can be nothing but a bear market rally. It is important to be prudent here, and take some gains. There is nothing wrong by playing a safety to win a game, in the long run. What have you got to lose, so the market goes up another 10 % on a rally and you lose out. Or you hunker down take your gains and live to play another day. Wait it out and see who's right. You would have to believe that the housing numbers, unemployment figures, major bankruptcy's, bank writeoffs, unrealized toxic assets, flu epedemic, export numbers, commercial real estate defaults, credit card defaults, pension underfundings, and that people really didn't lose their wealth they are not mired in debt and they have lots of money to spend. If you believe the market can shrug all this off, put the hammer down.

May 04 10:23 AM

[Stimpy:]

SURE, 9 Trillion in FED liquidity goes a long way.

What happems when iy comes back out?

Hint: 1934

May 04 11:37 AM

[VP of Commo...:]

It is interesting that so many people are trying to compare this event (credit/currency crisis) to past DOW events. Evidently this qualifies as "out of the box" but I would think the best comparison would be to the Asian financial crisis of 1997. Not only is that relatively recent, but the root causes and effects are quite similar.

Using that as a comparison we are nearly 3 years in, as many bankers, builders and realtors saw the beginnings of this in 2006. We are 1 year in from where equities really started to deteriorate and 6 months removed from the freefall. My point is that the Asian credit crisis did not take but a few years to heal. Those expecting an L or U shaped bottom as well as many bear market rallies and retracements, may be in for a surprise.

I think it's great to look back at the 30's or the 70's, but the 30's especially seem to dissimilar to be valid. It seems the driving factor to looking that far back is that event was the nearest drop in equity percent value to current. The 70's/early 80's are often used to compare because of similar projected unemployment and/or an oil spike. However the primary reasons behind then and now are violently different (for now, impending inflation?).

May 04 12:00 PM

[Dave Wrixon:]

The Asian economies you are referring to are about as similar to the US economy as Chalk and Cheese.


On May 04 12:00 PM VP of Common Sense wrote:

> It is interesting that so many people are trying to compare this
> event (credit/currency crisis) to past DOW events. Evidently this
> qualifies as "out of the box" but I would think the best comparison
> would be to the Asian financial crisis of 1997. Not only is that
> relatively recent, but the root causes and effects are quite similar.
>
>
> Using that as a comparison we are nearly 3 years in, as many bankers,
> builders and realtors saw the beginnings of this in 2006. We are
> 1 year in from where equities really started to deteriorate and 6
> months removed from the freefall. My point is that the Asian credit
> crisis did not take but a few years to heal. Those expecting an L
> or U shaped bottom as well as many bear market rallies and retracements,
> may be in for a surprise.
>
> I think it's great to look back at the 30's or the 70's, but the
> 30's especially seem to dissimilar to be valid. It seems the driving
> factor to looking that far back is that event was the nearest drop
> in equity percent value to current. The 70's/early 80's are often
> used to compare because of similar projected unemployment and/or
> an oil spike. However the primary reasons behind then and now are
> violently different (for now, impending inflation?).

May 04 12:20 PM

[altaman:]

Can someone please point me to any signs of recovery, in the real underlying economy, that are not the result of extraordinary manipulations by the government/ financial/ media complex in capital flows and financial reporting standards? I am seeing lots of terrible news, from broad sectors of the economy, being spun as "better than expected" but that is hardly evidence that a normal recovery is near. Sure a rising stock market is normally predictive of economy recovery but does anyone rationally expect a turnaround by year's end and isn't there just a whiff of manipulation about the surprising rise in insolvent financials given Goldman's huge trading for its own account?

May 04 12:32 PM

[L S:]

There are a 1,000,000 different bloggers and posters out there, with 1,000,000 different opinions. No one can reliably predict what's going to happen. I don't care if you review past charts or trends, use statistical analysis, or simply base your predictions upon the phases of the moon, NO ONE gets all of their predictions right, even the so called experts. If this was easy, actively managed funds would regularly beat index based ETF's. The facts prove that they don't.

So... I love all the talk. It's entertaining...particu... the calls I've seen lately saying "Buy and Hold is Dead!!!". I'll be content to sit back and follow the old philosophies of Diversification, Dollar-Cost Averaging, and regular portfolio rebalancing. It ain't glamourous. It doesn't make for an interesting article. But down the road, I'm guessing this approach will beat 95% of the investors who think they somehow know more about the market then everyone else. The road to bankruptcy is paved with the bodies of those who think they are going to beat the odds and the market. I don't plan on being one of them.

May 04 01:13 PM

["MADE IN SO...:]

You are too late boy, must make this comments at DJIA at 6500.
Now, when sharks are feeded and at any point may go for an exit, you are bullish?

May 04 01:21 PM

[Whippet:]

Great! Articles like this and headlines over the last week are no better confirmation of a dead cat bounce. Gravity, entropy, and REALITY will come back into play within the next few months. Folks, at least hedge your long positions and take some of your profits soon.

May 04 01:57 PM

[HardwoodFlo...:]

Good article. There is a great technical trager at Afraid to Trade blog. Anyone interested in some really good technical information should check out that site.

May 04 02:20 PM

[donzelion:]

I like comparisons to Asia and find the Asian financial crisis helpful and instructive - but a lousy analogue Southeast Asia had a currency crash that turned bank holdings into disasters - waves of bankruptcies swept each country that were orders of magnitude greater than even '08's set of big company busts. Southeast Asia rebounded fairly quickly due to export-driven growth and large, cheap labor supplies. None of these factors compare at all with the developed world today.

America's economy is much more comparable to Japan's than to Indonesia/Thailand/Mal... Our recession will parallel their own more than it will parallel the Great Depression, the Stagflation 70s, Asia/Russia/Mexico or other busts.

On May 04 12:00 PM VP of Common Sense wrote:

> qualifies as "out of the box" but I would think the best comparison
> would be to the Asian financial crisis of 1997. Not only is that
> relatively recent, but the root causes and effects are quite similar.

May 04 03:15 PM

[doubleguns:]

Asian crisis was just that, Asian. This is world wide like the pandemic.


On May 04 12:00 PM VP of Common Sense wrote:

> It is interesting that so many people are trying to compare this
> event (credit/currency crisis) to past DOW events. Evidently this
> qualifies as "out of the box" but I would think the best comparison
> would be to the Asian financial crisis of 1997. Not only is that
> relatively recent, but the root causes and effects are quite similar.
>
>
> Using that as a comparison we are nearly 3 years in, as many bankers,
> builders and realtors saw the beginnings of this in 2006. We are
> 1 year in from where equities really started to deteriorate and 6
> months removed from the freefall. My point is that the Asian credit
> crisis did not take but a few years to heal. Those expecting an L
> or U shaped bottom as well as many bear market rallies and retracements,
> may be in for a surprise.
>
> I think it's great to look back at the 30's or the 70's, but the
> 30's especially seem to dissimilar to be valid. It seems the driving
> factor to looking that far back is that event was the nearest drop
> in equity percent value to current. The 70's/early 80's are often
> used to compare because of similar projected unemployment and/or
> an oil spike. However the primary reasons behind then and now are
> violently different (for now, impending inflation?).

May 04 03:22 PM

[Market Sniper:]

What we see unfolding here is not comparable to any historical analogy in the recent past. The Asian Contagion was a rolling currency crash. The 1930's was a deflationary collapse with limited government intervention by current standards. This is more like the South Seas Bubble Collapse with a modern fractionalized banking debt system collapse thrown in for good measure. What seems not to be understood by authorities is that there are CONSEQUENCES for this type of irresponsible monetary and fiscal policies. We are going down an old, old well trod road at the end of which lies nothing good. Got gold?

May 04 03:30 PM

[waf76:]

I think a recovery is on the way but lets not get too ahead of ourselves. There are great companies out there, still profitable, sitting on a lot of cash. The apples and googles of the world. They will perform well regardless and you can very well see a v shaped recovery in their stock prices. Look for these types of growth stocks along with any beaten up stock thats has a decent yield. Can't really go wrong with that approach. You need to tread more carefully around the financials. It pays to be speculative but understand that thats what ur doing, being speculative. All it takes is one shoe to drop to wipe out the previous 8 week gains.

May 04 04:50 PM

[Just Say Whoa!:]

>All it takes is one shoe to drop to wipe out the previous 8 week gains.

At this moment, the likely culprits:

1) CRE crash
2) Eastern Europe crash
3) Another unknown Black swan crashes?

May 04 05:12 PM

[MGA_1:]

This is a pretty darn good rally, but even after the initial crash of 1929 the market had a 50% rally.

I wish we were out of the woods, but that's simply not the case. We are currently in between stages of real estate defaults that going to bring out the bear again. The defaults rate looks to be picking up again probably around mid summer.

There will be lots of bear market rallies, but I wouldn't look for the true bull market to start until most of the bad debt has been cleared out of the US economy.

May 04 06:16 PM

[Alphameister:]

I'm taking profits in stocks that should double from where I'm selling them to buy stocks that should triple from where I'm buying them. It's that kind of market! Shades of 2003. Whatever you might think of prospects for US stocks, check out the amazing opportunies among Chinese stocks. It's the buying opportunity of a lifetime.

May 04 06:19 PM

[VP of Commo...:]

I'm just saying many people have made many comparisons of the current to the past, and many other people have stated that the present will at some point resemble some past event, but maybe the event we should be studying isn't obvious.

I get the Japan comparisons, right up to the point where our government intervention differed from theirs. The biggest difference being that their government took a decade to fully admit what was going on.

I also agree that a credit contraction of this size has not occurred before, but the basis of my comparison is that monetary flow was interrupted, theirs via the bhat, ours via poor underwriting.

Finally while our economy and that of Thailand may be very dissimilar the repurcussions of both have been felt world wide, and "while history does not repeat, it usually rhymes".

May 04 06:27 PM

[Wisdom vs. ...:]

i usually say 'most likely,' but i do not need to today. two recovery fundamentals, as inviolate as the law of supply and demand, are being ignored:

new jobs are not being created, and state sales tax receipts continue to be terrible. until new jobs get created and sales tax receipts quit stinking there is no recovery, period. generally, you cannot start a rally with a housing surplus either (yeah, THAT would be 'most likely' lol).

note, i am not bagging on traders, just warning the enthusiastic

May 04 07:45 PM

[mastic trac...:]

So yes...clearly a beta bounce off the bottom, for market participants at this point "less than expected losses" are positive, bank "profits" are positive regardless of the way they were created, "leveling" of economic indicators are positive even at abysmal levels...the V shape would make sense ceteris paribus 2007...but it is not 2007....look at tax receipts, corporate profits etc....this will all be paid for, just try no to look surprised when the bill comes.

Also, I am not a technician, but an interetsing weekly inverted head and shoulders (if that is what it is called) is forming in most equity indexes. I agree that we could see another 10% maybe, that will pull in those who think they missed "it", but a retest of the 750 range on the 500 could be possible. I agree with MGA that there are still some skeletons that could easily and likely derail sustainability.

On the surface, 10 weeks of positive upside without a correction is pretty unnerving, when all of the news is out, hedging and profit taking may be best as I do not expect an "economic" V shape.

May 04 07:48 PM

[anarchist:]

Toss your charts in the dust bin, forget the dismal financial news as this rally has legs at least to S&P 1000. We have a rally driven by short sellers caught with their shorts down. A rally started and there has not been an appreciable pull back for the shorts to get out and rebalance their portfolios and now they are running for the exits. Time to take another look when we are at S&P 1000 for a possible correction not until.

May 04 09:48 PM

[bigbaboon57:]

This rally and the economy's bump will last no longer than the stimulus money, than the market will be in worse shape than ever. All the borrowed and printed money will prop the market/economy up in the short term, but in the long term the market and economy will slump worse than ever. You can't solve a problem caused by excessive debt with more debt, only postpone it.

May 05 12:02 AM

[cayman:]

Nice charts, and very interesting. There had to be a technical bounce at 6500 on the Dow that took it back up. But in the longer term picture that aint something I'm buying.

The Dow looks vulnerable to lower than 6500, almost 5000 and even 4500. One has to ask the question will the damage done by the obliterated stocks bring ´down the others that were just staying above water. I think it will becaue of the economic damage done. Even in Japans long nightmare they had nice rallies.

May 05 03:19 AM

[Hmm?!:]

How is it the Trillions of new debt will be repaid?

The Obama administration spends a couple Trillion dollars.
Then I see their first round of budget cuts.......100 Million......!!!

Great...they only have to cut a 100 million dollars from the budget 10 million more times and we are at a Trillion dollars in budget savings. Half way home!

Never mind the treasury bond interest, the government can just bail out the treasury later.

Now today Obama figured out the corporations are just hiding the extra cash we need........somewhere.... we will get it all back.

Really! It's all sunshine.....pass the heroin please.

May 05 04:03 AM

[Lakeaffect:]

Last fall, the economy wasn't as bad as the pundits and press said it was. That was merely a function of the Election, as the Democrats were painting a doomsday scenario so they could take over our government.

Now the same pundits and press are signaling "All Clear". The current administration is anxious to get this economic crisis in the rear view mirror so they can get on with more pressing items on it's agenda. As part of that effort, they can take credit for saving us all from Armageddon.

May 05 08:22 AM