In assessing the outlook for the financial markets, it may be wise to follow the rule of Presidential politics and wait until after Labor Day to undertake a thorough evaluation. In recent weeks, the markets have given us a great deal of volatility with no clear trend, and a particularly mixed bag of technical and sentiment indicators.
Last week, the Dow lost a mere 0.3% after moving over 100 points in three of five sessions, and crude oil finished 89 cents higher after gaining $6 on Thursday and losing $6 on Friday. Technically, U.S. stocks remain in a halting recovery pattern following the July 15 low, and there has been some constructive leadership from the technology sector and small-caps, but the advance overall has hardly been dynamic and most key indexes remain in longer-term downtrends. Sentiment indicators are similarly mixed. There are certainly examples of extreme pessimism (e.g. surveys of consumer sentiment are at 27-year lows!), which is positive from a contrary opinion standpoint, but there are signs of near-term investor complacency as well (e.g. the demand for protective equity put options is currently near the lowest level of the year).
The bond market has been sending a very different message from the stock market about the economic outlook and whether we have turned the corner in the credit crisis. The recovery in U.S. stocks since mid-July has occurred alongside a notable increase in credit spreads (i.e. the yield premiums of risky bonds over Treasury bonds), which are at their widest levels since the credit crisis began a year ago. The forced capital raising (to the tune of hundreds of billions of dollars) on the part of banks and the GSEs (Fannie Mae and Freddie Mac) to offset mounting loan losses, combined with rising default risk from non-financial borrowers, has precipitated a general upward re-pricing of risky credit.
Bond markets are signaling that we are not close to being out of the woods in terms of the credit crisis, the housing market downturn, and the broader economic recession. This is consistent with the leading economic indicators we track from the Economic Cycle Research Institute [ECRI], which have deteriorated further in recent weeks, prompting the forecasting firm to state that it is "crystal clear that there is no business cycle upturn in sight."
In light of continued heightened economic risks, and the prospect that the recession could be more protracted than is currently discounted by the stock market, it is still too early have conviction that a major stock market low was reached on July 15. Bear Markets are a process of risk subsiding over time as excesses are corrected. We are now ten months into this bear market, so it is appropriate to begin to look forward to a healthier market environment, but it still seems premature to take a more aggressive posture towards the stock market. We think the prudent course is to wait for greater clarity before taking substantive action in equity allocations.
Finally, permit me to recommend the just-released documentary "IOUSA," which examines the rapidly growing national debt and the fiscal crisis our country faces due to unfunded entitlement programs. The film is non-partisan and very well done. It will hopefully elevate this pressing issue in the nation's politics so that the next administration and Congress, from whichever party, will make the difficult choices necessary to get the country on a sound fiscal footing.