Investors Should Be Careful And Stay Flexible

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 |  Includes: SPY
by: Thomas J. Feeney

The stock market sold off hard into the close of a bad day, week, month and quarter. A 2.5% decline in the S&P 500 (NYSEARCA:SPY) Friday contributed to a costly decline of 13.8% for the third quarter. Going into the fourth quarter, the S&P is down 8.5% year-to-date, and the index is ten points below its level at the end of the third quarter, 2010.

While most world stock markets are already down 15%-30% from their recent highs, the vast majority of analysts and strategists remain adamant that the United States is not heading into a recession. With housing and unemployment continuing as intractable problems, and most economic statistics at or near recession levels, a bullish economic forecast seems increasingly untenable.

More important to the health of the economy and the securities markets than ordinary business conditions is the fate of the European banking system. Can it emerge in reasonable health from the European debt crisis? Should monumental debt burdens overwhelm the best efforts of Eurozone governments and central bankers, the free movement of credit through the world financial system could come to a screeching halt. World GDP would plummet with recession affecting most of the world.

Whether or not we enter recession is important to equity markets. Over most of the past century, stocks have logically fallen far more deeply when the economy contracts than when it avoids a formal recession. And while averages are not forecasts, they lay out potential paths. Since the early-1900s, stocks have typically fallen almost three times more after a recession starts than in the period leading up to the economic decline. Assuming we are not yet in recession, that past pattern presents an ominous possibility should economic conditions weaken further.

Having forecast repeatedly that we have not yet emerged from the long weak cycle that began in 2000, we have maintained a risk-averse posture for client portfolios. As a result we are up slightly for the disastrous (for most) third quarter and for 2011-to-date as well. Even a relatively modest allocation to equities has produced some appreciation in a very tough environment.

The danger of a precipitous decline is certainly a real possibility should we experience some form of European debt default. If a true “get me out at any price” capitulation results, we would be looking for an opportunity to add significantly to our equity position for at least a short-term recovery rally. Whatever unfolds, the next few weeks and months should prove interesting. Be careful and stay flexible.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.