Stock Market Wakes Up To Unresolved Credit Crisis

Includes: DIA, QQQ, SPY
by: J.D. Steinhilber

The S&P 500 dropped 4.6% last week (down 9.3% year to date) and sits just 20 points above its lowest closing price of 2008, which was recorded on January 22. After rallying the prior two weeks, stocks rolled over when confronted with stark evidence that the economy is in recession and the credit crisis is nowhere close to being resolved. The ISM Non-Manufacturing Index, which measures the health of the U.S. services sector, plunged 12.5 points to 41.9 in January, the lowest level since October 2001, a period when the economy was in recession.

A reading in this index below 50 indicates contraction. Given that services account for 2/3 of the U.S. economy, this report goes a long way towards explaining why the Fed has been panicked of late.

Indexes of bank stocks gave back a good portion of their recent bear market rally, falling 8% last week on new evidence that the credit crisis is spreading beyond the residential mortgage loan sector. Senior corporate loans used in connection with leveraged buyouts suffered sharp losses last week. Standard and Poor's index of such loans fell to a record low of 86.28 cents on the dollar at the end of last week. Bloomberg reported last Friday that banks are sitting on $160 billion of leveraged corporate loans that can't be sold amid a buyer's strike involving all forms of risky debt.

While the unwinding of the credit bubble continues, we saw an interesting development in the Treasury bond market last week. Longer-term Treasury yields rose last week (30-year yields jumped 11 basis points to 4.42%) despite sinking stock and corporate bond prices. Since last summer, Treasury yields have plunged due to the flight-to-quality caused by the credit crisis and expectations of economic recession.

Last week's action in the long-end of the Treasury market may indicate that bond investors are waking up to the aggressive reflationary policies of the Fed and the federal government. Commodity indexes surged to new record highs last week, with wheat prices (up 140%! year over year) leading the charge. The Treasury market will also be challenged by a sharply higher supply; last week the government reported that it expects the federal budget will more than double this year to a near record $410 billion. Notwithstanding the recessionary economic backdrop and credit crisis, current Treasury yields make no sense to us given ongoing inflation pressures and deteriorating near term budget deficits.

Turning back to the stock market, it appears as though a test of the January lows (for the S&P 500: 1270 on an intra-day basis and 1310 on a closing basis) is currently underway. The weight of the technical and sentiment-related evidence suggests that this re-test will be successful, but we wouldn't advise aggressively trading this idea.

As it stands now, the S&P 500 is down 15% from its October 9, 2007 peak. In the 12 bear markets that have occurred since 1945, the median peak-to-trough decline is 27.5%. Viewed in this context, the current decline is 55% through the post World War II median bear market decline.

Given the aggressive reflationary measures currently being applied by the government, and the fact that S&P 500 valuations, based on normalized earnings, have already dropped to post-World War II median levels, it is reasonable to suppose that this bear market decline won't reach the 27.5% median level. The inflationary measures being taken by the government can reasonably be expected to support share prices in addition to hard assets. It is entirely possible to have a slump in the economy accompanied by stable to higher share prices simply because of monetary inflation.

However, it is a reasonable assumption, given the lack of widespread acknowledgement that the economy is in recession and that the unwinding of the credit bubble has much further to run, that the ultimate bear market low lies somewhere in the future. Consequently, it makes sense to remain patient and retain a healthy amount of liquidity in portfolios.