One Eyed Guide's  Instablog

Almost everyone understands that the stock markets are highly valued right now but there seems to be little understanding of what is going to happen when it rolls over. 

Bulls feel any correction will be minor and quickly resolve itself as higher earnings are announced (the best case scenario.)  This is the same thinking that resulted in the recent $11 Trillion (or whatever other large number you agree with) reduction in America’s net worth.

The bears think that earnings estimates are not achievable and bad news will drive down the markets until everybody despairs that it will ever go up.  The bottom for the bears tracking the history of the S&P500 is 460 or lower.  Many bears predict a worst case scenerio of both the “Greater Depression” from the economic collapse and hyper inflation from money printing.    There is no economic theory that ends up with both of these within the next year or two.  To get hyper inflation without runaway economic activity, you have to first destroy the economy (Germany at the end of WWI or Zimbabwe’s farm takeovers) then print money.  While what Obama is doing may not be exactly right, no one can argue it rises to the destruction of Mugabe and it may actually help. The concern about printing money causing a Depression is unfathomable:  This either starts growth (eliminating the possibility of a Greater Depression) leading to (maybe hyper) inflation or does not affect growth/inflation as money goes into a liquidity trap.

The most likely scenario is much different than these two stock market scenarios.   Sometime in the next 6 months the stock markets will be substantially lower at the end of a month than it was at that the beginning because of the natural ebb and flow of the markets.  Even if this starts as a minor correction to a liquidity driven market, this will almost certainly trigger a decline in the Conference Board Leading Economic Indicators because:

1.       Reversing the recent stock market gains by itself would eliminate most of the positive trend.  August LEI were up by 0.62, of which 0.30 was from stock gains.  Just reversing August gains would move the index -0.6

2.       A falling stock market will probably reduce consumer expectations below whatever level it is at.  As this was one of the August LEI positives reversing it will be enough to put the LEI in negative territory. 

There is unlikely to be any offsetting increase in manufacturing activity to maintain a positive LEI .  In fact, at the same time that the stock market can be expected to have a correction, manufacturing will probably have its own correction which will push the leading indicators very negative because:

1.       The end of the Cash for Clunkers has brought auto sales back to trend so a reduction in manufacturing activity is to be expected after autos restock.

2.       Some of the recent manufacturing increases were due to inventory rebalancing, not rebuilding. Manufacturing inventories at 1.38 months remain above the 1.2 month level that was typical from 2002 to 2007.  Once rebalancing is complete, we can expect further decreases in manufacturing as inventories are drawn down. 

3.       Retail inventories are low for this time of year which raises the possibility that there will be out of stocks at xmas time, further depressing retail sales.  Alternatively, there could be a sudden rush to stock up before Xmas (unlikely with retails sales down 8.8% for the first 9 months of the year.)

The drop in the LEI will cause a panic that we are in the dread “double dip” recession.  Fear of this will accelerate the drop in the market until it reaches some sort of normal valuation from the current levels.  You can pick your own level of fair valuation but a 15 PE on trailing 10 year earnings seems reasonable given the amount of liquidity being put in the system and the almost 100% certainty the there will be another stimulus bill if the “W” starts to appear in the recession profile.  This gives a bottom around 640 on the S&P500 using current projections into 2010.  Traditional market bottoms using PE’s of 5 or 8 don’t seem very likely given the amount of money that will be pumped into the system.

There is a chance that there will be a quick drop if the market has a pullback prior to December 31 which causes a rush for the exits by money managers who need to lock in profits before year end.  This is ugly but there is a lot of support until Dec 31 as basically everybody is going to do everything they can to make their yearend bonus.  Earnings surprises with poor sales results like J&J seem to be the norm and the market should be able to shrug these off.

If you look at history, we will not have a double dip recession unless the problems in banking (forecasts of up to 1000 banks failing) prevent lending for smaller firms from opening back up when there is actually demand for lending.  This was an issue with both the Recession of 1937 and the Recession of 1895 (part of the Panic of 1893.)  The Panic of 1893 was the end of the first Gilded Age and resulted in a double dip recession with persistent unemployment that did not resolve until banks became solvent again.  Sound familiar for the end of the New Gilded Age?

The most likely scenario for the stock market is a nasty decline back to previous lows starting in earnest in January 2010.  Old lows will probably be broken if we enter a true double dip recession but even then the liquidity and deficit may keep earnings at a level that prevents Great Depression like lows in the market.

We’ll see.

Disclosure:  None for this post