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Meltdown
Don't blame Standard and Poors. Blame the economy.

Raul Elizalde - Monday, August 8 2011

Today the S&P 500 went down 6.66%, or an astonishing 80 points from the close of the prior day. We saw this before. In fact, 20 times since 1971 the S&P dropped by more than 5% in a single day. What now?

The S&P went on to lose for a second day on only 5 of those 20 times. Only twice the S&P did not have a higher close within the following 5 trading days or the following two months. A short-term rebound, therefore, is not out of the question. At least there is a good case for stating that short-term support could form around today's close, at least judging from history.
Day change
Next day change
Highest following week
Highest following two months
10/16/1987
-5.2%
-20.5%
-8.6%
-8.6%
10/19/1987
-20.5%
5.3%
14.9%
14.9%
10/26/1987
-8.3%
2.4%
12.3%
12.3%
1/8/1988
-6.8%
1.7%
3.6%
10.7%
10/13/1989
-6.1%
2.8%
4.0%
5.7%
10/27/1997
-6.9%
5.1%
7.1%
12.2%
8/31/1998
-6.8%
3.9%
6.9%
13.4%
4/14/2000
-5.8%
3.3%
6.3%
9.0%
9/29/2008
-8.8%
5.4%
5.4%
5.4%
10/7/2008
-5.7%
-1.1%
0.7%
1.0%
10/9/2008
-7.6%
-1.2%
10.3%
10.5%
10/15/2008
-9.0%
4.3%
8.5%
10.8%
10/22/2008
-6.1%
1.3%
4.9%
12.2%
11/5/2008
-5.3%
-5.0%
-2.3%
-1.9%
11/6/2008
-5.0%
2.9%
2.9%
3.3%
11/12/2008
-5.2%
6.9%
6.9%
9.7%
11/19/2008
-6.1%
-6.7%
10.1%
15.9%
11/20/2008
-6.7%
6.3%
19.1%
24.2%
12/1/2008
-8.9%
4.0%
11.5%
14.5%
1/20/2009
-5.3%
4.3%
5.0%
8.6%

 

But a little digging reveals that the current rout (which we foresaw in our last newsletter, Markets and Politics, July 25) has less to do with a market blip, the Washington circus, or the downgrade by Standard and Poors, and much to do with the reading of the latest economic indicators.

In April, the US Bureau of Economic Analysis (BEA) released its first preliminary estimate of 1Q GDP at 1.8%. In May it released its second estimate at 1.8%, and in June it released a third, slightly up at 1.9%.

Then, on July 29, the bureau dropped a bomb: all those releases were way off. The actual number was a truly dismal 0.4%. This was followed by very weak PMI (Purchasing Managers Index) and NMI (Non-Manufacturing Index) releases. Adding insult to injury, the revelation that economic numbers were far weaker than anyone had been led to believe came at the same time as Congress pushed through a $2.7 trillion spending cut package. Combine a stalled economy with a massive austerity package and you have a pretty straightforward recipe for recession.

Equities, which depend on a growing economy to generate earnings, are in serious trouble. Projected earnings are likely to be overstated, making forward-looking P/E ratios higher than current calculations.

Under that light, the equity market rout can’t be seen as a buying opportunity until earnings projections are recalculated with the new understanding that the economy has virtually ground to a halt, and that a contractionary package passed by Congress is likely to set the economy in reverse.

From a technical perspective it is quite possible that the market will rebound somewhat in the next day or two, as we have seen. But unless the economy gets some good news soon, there is little reason to interpret the carnage of the last few days in any other way than a response to a fresh, more accurate view of economic activity, one that realizes that the economy is far weaker than what the consensus had been until just a few days ago.

Can a recession be avoided? Recessions are fought with fiscal or monetary stimuli.  Fiscal stimulus is out of the question as far as we can tell: more spending or lower taxes have virtually no chance in Congress. That leaves monetary stimulus as the only tool left in the shed. And a blunt tool it is: rates are rock-bottom low, velocity of money has plummeted, and the Fed’s balance sheet is already huge. Still this is the only tool available, and we would not be surprised to see a new round of quantitative easing.

If the Fed decides to embark on QE3 then US Treasury bonds may well continue to rally despite the S&P downgrade. In fact this would have a neat political silver lining for the Administration – we reckon that the US Treasury would derive some pleasure at having its bonds going through the roof after being downgraded by what they see as a rogue agency.

A short-term bounce in equities, if it happens, has to be treated with caution. Some will be tempted to see it as a sign that today’s drop was overdone. More risk-averse investors may want to treat it instead as a gift: a golden opportunity to cut losses at a better level, or a welcome breathing room to lower the risk profile on their portfolios.

Doing this would prevent investors from participating in a strong, solid rebound and many analysts will insist on this. But as things stand right now, in our view at least, a bull market has little chance and no foundation.

-----------------------------------

We use quantitative measures to build and maintain portfolios for our clients, which we rebalance every quarter. We described our investment process in previous newsletters. If you would like to know more about how Path Financial’s investment process works, call us or send us an e-mail at the address below. We’ll be happy to set up a confidential meeting to discuss new paths to financial success.

Raul Elizalde | raul@pathfinancial.net | 941-350-7904

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