The second quarter started with a bang in the equity markets. The S&P 500 rallied 4.2% last week, cutting its year-to-date losses to 6.7%, and its percentage decline from the October 2007 peak to 13%. Having closed last week at 1370, the S&P 500 is approaching major resistance at 1385-1400, a level that turned back prior rally attempts in January and February. If we happen to break through this resistance zone, sentiment would undoubtedly turn a lot more positive on a shorter-term basis and the rally may well extend towards its next major resistance area at 1440-50.
The S&P 500 (SPY) has now rallied over 100 points since the Bear Stearns (BSC)-related panic lows on March 17. The markets are trading as though the worst of the crisis has passed and that newly installed government measures will prevent the sort of systemic, domino-like collapse threatened by the Bear Stearns episode.
Volatility has abated, as reflected by the nearly 40% decline in the VIX volatility index over the past three weeks. Importantly, stocks have been able to break the downside momentum and have demonstrated an ability to hold onto gains rather than promptly give them back, which had been the pattern through most of the first quarter. This resilience was on display last week; the stock market shrugged off Chairman Bernanke's implicit acknowledgment that the economy is in recession, as well as Friday's dismal employment report (the March employment survey showed a loss of 80,000 jobs, following revised losses of 76,000 jobs in both February and January).
We continue to believe that the burden of proof is on the bullish case, and that this rally should be viewed as countertrend until additional constructive evidence accumulates. However, we should be open to the possibility that the bear market lows are in place, and speculate upon the conditions that would underpin a bullish stock market scenario.
In our estimation, the bullish case is predicated on the assumption that the economy will experience only a mild recession, and that a modest contraction has already been discounted by share prices. History shows that bear markets end in the midst of recessions. It is a truism of the stock market that by the time a recession is finally recognized fully in the media, most of the bear market damage to stocks is typically done. If this turns out to be a mild recession, lasting perhaps only two to three quarters, without a sharp fall-off in employment and consumption, then the bear market may be largely over.
If the recession is more severe, accompanied by significant further drops in housing prices, employment, and consumer spending, then the stock market rally that began three weeks ago will turn out to be a bear market rally driven by the fact that stock market sentiment in the first quarter reached its most negative levels since the bear market bottom in 2003. (Contrary opinion analysis tells us that when the overwhelming majority is bearish, that side of the boat has gotten overly crowded, and price will move in the opposite direction from the one expected by the consensus).
Among this things we will be watching closely in the weeks ahead will be (1) action in the Treasury bond market, and (2) housing market data as we move into the important spring selling season. The Treasury market is currently priced for a severe rather than a mild recession, and for a continuation of the credit crisis since Treasuries have benefited from enormous "flight to safety" buying in the credit markets. If this recession is going to be mild, and if the stock market outlook is turning more positive, then we should in fairly short order see a downward reversal in government bond prices.
Housing will remain a focal point because it is the source of much of the stress in the economy and the credit markets. In light of the wide range of government stimulus and relief measures aimed at housing that have been enacted, there is a growing view that a housing market bottom is just around the corner.
Such optimists cite the fact that homebuilding stocks appear to have bottomed (homebuilding stocks are the best performing industry group thus far in 2008), and that affordability has greatly improved through the combination of price declines, Fed rate cutting, and a variety of government relief measures, the most recent of which was last week's Foreclosure Prevention Act of 2008, which, among other things, would help distressed homeowners and allow government agencies to buy foreclosed properties.
Our view has been that housing prices have considerably further (i.e. as much as 10%) to fall to clear excess inventory and bring pricing closer to historical relationships with household income levels. Our view of government intervention is that it will mostly delay, rather than prevent, this adjustment process. However, we may have to modify this view if the government resorts to the direct purchase or insurance of hundreds of billions of dollars of mortgages. For the time being, the upcoming spring selling season will provide important information about the current state of the housing market.