Can the Fed's Reflation Policy Stave Off Recession?

In yet another volatile and unsettled week of trading, the S&P 500 edged up 0.3% - not the sort of rebound bulls were hoping after the prior week's breakdown. The S&P 500 closed at 1458, 7% below its 52-week high reached in mid-October, and the question now on traders' minds is whether the market is headed back down towards the 1400 level, where August's correction ultimately found a bottom, or if positive seasonal trends (December and January are historically the two strongest months of the year) and hopes for additional rate cutting from the Fed can turn the market around from current levels and push the S&P 500 back above key resistance at 1500.

Markets are on high recession alert, which is the overriding reason for the lack of conviction among stock investors. The prevailing worries are depicted by the cover of the current issue of the Economist magazine, which features the ominous headline "America's Vulnerable Economy" and pictures a take-off on the advertisement for the original Jaws film. The swimmer on the surface - the U.S. consumer in a stars and stripes bathing suit - is about to be taken down by the oversized shark, which represents the housing market bust and the associated credit crunch.

There is no question the economy is in a pronounced slowdown. The point of debate is whether the economy is tipping towards recession, which would likely produce at least a 15% - 20% peak-to-trough decline in the broad stock market, or whether we are merely in a period of slow growth, implying that most or all of the bad news concerning the housing debacle and credit crisis has been discounted by the markets. While we are not prepared to forecast a recession and a bear phase in the stock market, we recognize that the risks of such an outcome are high enough to warrant a conservative investment posture.

The largest sector of our economy - finance - is under extreme pressure, and the strain from the financial sector can be expected to increasingly feed into the rest of the economy. We are now only a few months into the general mortgage credit crunch. As losses mount and balance sheets weaken, we should expect credit to get even tighter, notwithstanding the efforts of the Federal Reserve. The securitization model, which dominates residential lending and also encompasses a third of the commercial mortgage lending market, is under duress, and will not likely survive in its present form. Securitization has allowed riskier, more leveraged purchases because the lenders originating the loans did not have to carry them on their balance sheets.

The housing bust shows no signs of nearing, let alone reaching, a bottom. The CEO of Wells Fargo (WFC) noted last week that the bear market in housing is the worst since the Great Depression. The huge unknowns surrounding the housing market make it impossible to calculate the ultimate size of the losses on mortgage securities, but estimates of the damage are rising. Last week, Jan Hatzius, chief U.S. economist of Goldman Sachs (GS), estimated that losses tied to residential mortgages may total $400 billion, which would force banks, brokerages, and hedge funds to cut lending by as much as $2 trillion.

Consumer spending, which powers 70% of the U.S. economy, is clearly facing some serious headwinds. Consumers are confronted with falling housing wealth, looming resets in adjustable rate mortgages, tighter credit conditions constraining refinancing options, stagnant real incomes, a softening labor market, and higher food and energy prices. Retail sales growth is weakening, and the University of Michigan Consumer Confidence Index has dropped from 96 in January to 75 currently, the weakest reading in 15 years excluding the period directly following Hurricane Katrina.

While the financial markets are on high recession alert, they are still giving the benefit of the doubt to the optimistic case - that the economy will be able to avoid recession. The S&P 500 is still positive for the year and only 7% below its peak. High yield corporate bond spreads have widened but not nearly to the degree that would be expected if a recession were imminent. This optimism in the economy's resilience stems in significant part from expectations for significant further easing from the Federal Reserve. Due to persistent inflation pressures, soaring commodity prices, and a record low U.S. dollar, the Fed has been trying since its last rate cut on October 31 to wean the markets off of expectations of continued easing, but the markets aren't buying it. As of Friday, markets were pricing in a 90 percent chance of another rate cut at the Fed's next meeting on December 11, and a two-thirds probability of a further rate reduction in January.

It remains to be seen how the Fed navigates this treacherous environment. The Fed has demonstrated a willingness to cut rates in the face of soaring commodities and a tumbling dollar, so if the credit and housing crunch further depresses the economy and stock prices, we should not expect the Fed to be constrained by inflationary signals from acting to try to stimulate the economy, provided longer term rates do not spike due to inflation or weak dollar concerns. Reflationary Fed policy may limit the downside risk to stock prices and would be bullish for commodity and gold prices.

Given that we are clearly in an environment of heightened uncertainty and risk, and that credit crises have historically been associated with bear markets in stocks, we continue to advise a defensive approach to the markets. If we do get a bear market in stocks, the silver lining is that is won't be anything like the severity of the last bear market in 2001-2002, when stocks were much more highly valued prior to the decline.

Today, stocks are mildly overvalued from a historical standpoint, such that a garden variety 20% peak to trough bear market decline would set up an attractive buying opportunity. In the short term, with the market oversold, hovering directly above major support represented by the August lows, and entering a favorable seasonal period, we may be close to a bottom.

Although at this point we don't anticipate adding equity risk exposure to our model portfolios, a purchase of the S&P 500 on a drop to the 1410 level would be a reasonable trade in anticipation of a seasonal bounce.

Comments

[Georealist]

The housing "crisis" is just the poster child of the liquidity crunch...debt evaporation cycle that has the markets attention. The real concern of the Fed (bankers first and last) is banks. And here there are some very serious issues. It's banks/lending institutions that are the real engines of the credit conveyor belt and the Fed will do everything and anything to make sure confidence and liquidity are maintained. The sacrificial lamb will be the dollar. This is not such a big deal since the dollar was largely given up decades ago.
Will there be a recession? A year from now we'll have a new President....and we'll see the greatest rush of stimulative programs in US history..infrastructur... energy...etc. Wal Mart is safe for now. Inflation? Of course it will go up...and we'll hear that as long as the economy is growing and the populace is liquid enough to shop til they drop stuff will work out....sound familiar?