Market Outlook: Does the Tail Wag the Dog?

by: Bachar Samawi

Moody's Analytics lowered its outlook for the U.S. economy on Monday. Now it expects GDP to grow at 2% in the second half of 2011, and at 3% in 2012, instead of its previous forecast of 3.5% for both periods. Moody's cited the European debt crisis and U.S. debt ceiling political wrangling as factors, and said odds of a recession will increase if stock prices continue to fall. Are you confused?

First, it was said that the recent drop in stock prices during the past several weeks was caused by expectations for a weaker economy, and the possible increase in the likelihood of a recession. Now we are hearing that it is actually the other way around, that the reason the outlook for the economy is weak and the likelihood of a recession may rise is because of a possible weak stock market.

First it was said that the reason the European debt crisis has become an issue was because the outlook for the European economy dimmed. Now we are saying the reason the outlook for the U.S. economy has dimmed is because of the European debt crisis, and the U.S. and Europe are inter-linked. We used to hear that "if the U.S. sneezes, the world catches a cold." Now we hear that "if Europe sneezes, the U.S. catches a cold."

U.S. debt ceiling political wrangling? Isn't the debate of whether to raise the debt ceiling or not already behind us? Wrangling has become an economic factor?

It seems these kinds of conclusions are driven by a belief that it is all about confidence; if confidence is eroded, the market suffers. If the markets suffer, confidence is eroded, etc... However, confidence is based on projections, and projections can prove to be right or wrong, especially if such projections are themselves based on confidence. Is it all starting to sound like some kind of Voodoo?

At the end of the day, if confidence is key, the headlines can drive the market in the short run, even if the headlines are wrong. However, remember that headlines can always change. Most importantly the tail can't wag the dog forever because "the dog is smarter."

Unless we get hard data confirming recent economic pessimism, which has been already somewhat priced into the markets, then the recent bounce from the lows in the market can prove to be sustainable.

Disclosure: I am long KFT.