Stocks are in a choppy recovery phase from the selling climax that occurred on July 15. At that time, we thought that an interim bottom in financial stocks and an interim top in the commodity markets (especially oil) were needed to reverse the powerful downward momentum in the broad stock market, and that is exactly what has occurred.  Bank stock indexes are up 40-50% since their capitulation low and oil prices have retreated nearly $30/barrel in recent weeks. 

We will only know in hindsight whether the July 15 low was the bear market low. However, until much more evidence develops to suggest otherwise, our assumption must be that this is another relief rally in the context of an ongoing bear market, and that a lower risk buying opportunity still lies in the future. Our expectation is for a range-bound stock market for the balance of the third quarter and into the election. Risk and reward appear to be about evenly balanced at present. Using the S&P 500, we think the upside potential will be limited to 1350, and downside risk extends to 1150. Given that the S&P 500 is currently fluctuating within the middle of this range, we are neutral on the market looking out over the next several months. Taking a longer-term view, persuasive arguments can be found in both the bullish and bearish camps.  Accordingly, we think the prudent course is to wait for greater clarity before taking substantive action in equity allocations.

While a cautious investment posture is still advisable, we don’t see the need for maximum defenses. A variety of measures suggest that the worst part of the bear market is behind us.  The S&P 500 has already declined over 20% from its October 2007 highs. According to Standard and Poors’, in nine of the past 12 bear markets, the S&P 500 made double-digit gains in the 12 months after crossing the 20% decline threshold. At the mid-July low, 44% of the prior bull market’s gains (from 2003 to 2007) were surrendered, which is right in line with the typical bear market. Relative to long-term, trendline earnings (smoothed for the fluctuations of the business cycle), S&P 500 valuations are the most attractive since the bear market lows in early 2003.

The principal risk confronting the stock market is that the recession could turn out to be deeper and more protracted than is currently discounted by the stock market.

Although recessionary bear markets invariably bottom well before the economy troughs, the current economic contraction, which began in the fourth quarter of 2007, could extend well into 2009. The basic reality, which is still under-appreciated by Wall Street, is that we are in a post credit bubble environment. Excessive and irresponsible lending and borrowing in the decade culminating in 2007 is the root of the problem, and the economy is now in a difficult deleveraging phase. We have a systemic banking crisis, where the ability and willingness of banks (and other credit creation/delivery mechanisms) to lend has been severely compromised.  Meanwhile, with asset prices in retreat, borrowers are in debt retrenchment mode. The result is that new credit creation has plunged by the largest amount in decades.  Not only has credit availability been tightening, private sector borrowing rates have been spiking. A composite of bank lending rates to private borrowers has spiked 70 basis points in the past three months and is back to levels that existed before the Fed began slashing the fed funds rate (the borrowing rate for banks and brokerages) a year ago.

It is unclear how long the contraction in the economy will persist. The path of housing and energy price will obviously be critical variables. We will be looking for an upturn in the Economic Cycle Research Institute’s [ECRI] leading economic index for a signal as to when the stock market can begin looking ahead to the next business cycle recovery.  For now, ECRI’s leading index remains stuck at cycle lows, prompting the forecasting firm to comment that a “business cycle recovery is no where in sight.”

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J.D. Steinhilber

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