Printer FriendlyWeekly Market Commentary—March 10, 2008
For much of February signs of healing were evident; aggressive policy actions by the Fed helped to lower liquidity premiums and contain the widening in credit spreads – and even helped the stock market to stabilize.
On The Edge
- For much of February signs of healing were evident; aggressive policy actions by the Fed helped to lower liquidity premiums and contain the widening in credit spreads – and even helped the stock market to stabilize.
- Last week brought additional negatives to the economy and markets, putting our outlook for a classic mid-cycle slowdown scenario for the markets at risk and raising the odds of recession.
- During the past 20 years, we have only seen three peak-to-trough declines of the current magnitude or greater - they took place in 1990, 1998, and 2000-02. The declines that took place in 1990 and 1998 may be most comparable to the current environment. Following the 1998 decline of 19%, the 12 month gain in the S&P 500 was 40%. After the 1990 decline of 20%, stocks rebounded 34% over the next 12 months.
- While the market trough may still be ahead, it is important to try keep in mind a longer term outlook. Since WWII there have been 16 market declines of around the current magnitude of 14% or more. On average, 12 months after hitting the trough stocks were up 32%.
Last week’s market commentary compared the drop in consumer sentiment – such as expectations for personal finance and economic growth – to levels last reached in 1980, while noting that measures of economic, social, and environmental conditions today are far superior to those in 1980. The improved measures support our outlook that the economy will avoid a deep recession similar to that of the early 1980s and the associated 27% peak-to-trough stock market decline. However, this week’s market commentary focuses on increasing negatives facing the economy and markets that put our outlook for a classic mid-cycle slowdown scenario at risk.
After the Fed’s aggressive policy actions in late January to improve credit conditions, such as the 125 basis points of rate cuts and the easing actions of the Term Auction Facility, the stock and high yield bond market stabilized, and in the weeks that followed, signs of healing were evident. However, the indicators of improvement in the underlying health of the economy and markets changed last week. During the past week:
- credit spreads renewed their widening trend after stabilizing for much of February, and liquidity dried up, resulting in a seizing up of the credit markets;
- while the stock market held the intraday lows of late January, the S&P 500 broke away from the 1998 pattern with a renewed decline;
- a second month in a row of job losses was reported – surprising after economists’ consensus expectations for a gain;
- the dollar suffered a sharp decline to an all time low, and oil prices rose to $105, an all time high.
The combination of these factors put our outlook for a classic mid-cycle slowdown scenario for the markets at risk and increases the odds of recession. However, it is worth noting that most economic data reported in recent weeks are not signaling recession, earnings guidance has been generally stable in recent weeks outside of financials and some retailers, and real-time trade association data such as weekly readings on retail sales, rail car shipments, filings for unemployment benefi ts, and lending continue to point to growth.
Each of the negative factors that intensified last week warrants further exploration.
Credit Market
The rapid deterioration in the credit markets can be illustrated many ways. The best way may be to track the spread between the yields of off-the-run and on-the-run Treasuries, which demonstrates both the improvement of market liquidity following the late January policy actions and the sudden deterioration seen in the widening spread in recent days.
Stock Market
During the past 20 years, we have only seen three peak-to-trough declines of the current magnitude or greater - they took place in 1990, 1998, and 2000-02. The 2000-02 decline was prompted by very different conditions (record high stock market valuations, over-spending and over-hiring by corporations, soaring dollar, etc.) and was long and painful as the Information Technology sector deflated, while leaving most stocks relatively untouched until mid-2002. However, the other two major declines which took place in 1990 and 1998 may be comparable to the current environment.
As you can see in the chart, the stock market has started to break away from the 1998 pattern that we have cited as a guide to the current downturn given the very similar credit, profit, and economic conditions to today.
Instead, the market may instead be following the 1990 pattern – when the savings and loan crisis cost $160 billion, oil prices soared, the dollar continued to slide, and a mild recession combined to pull stocks down 20%. If the market continues to follow this pattern, we may see some additional downside.
Following the 1998 decline of 19%, the 12 month gain in the S&P 500 was 40%. After the 1990 decline of 20%, stocks rebounded 34% over the next 12 months.
Economic Data
The March 7 release of the February employment report came in below expectations, posting a 63,000 loss versus expectations of a 22,000 gain. The back-to-back monthly declines in employment raise the odds of a recession. The underlying detail of the 63,000 drop in non-farm payrolls in February was weak, with private sector employment falling 103,000 – the third consecutive monthly drop. The employment declines were widespread, with losses in construction, manufacturing, retail trades, fi nancial services, and business services. On balance, the recent data continue to paint a picture of an economy that is teetering on the edge of recession. While many of the conditions that need to be in place prior to a recession are not evident – rising wages, inventory overbuild, Fed raising rates, profi t margin squeeze – other indicators, such as today’s employment report and the recent weak readings on the manufacturing ISM, paint the picture of ongoing deterioration.
Dollar and Oil
Oil prices surged to over $105 from $91 at the end of January, and the dollar fell 3% over the same time period. The renewed decline in the dollar may discourage foreign nvestment while rising oil prices act as a drag on domestic growth.
Looking Forward
Until effective action is taken to address the worsening problems in the credit markets, we believe that the stock and credit markets may continue to weaken. However, with stocks down over 6% in the last seven trading days and 17% from the peak of October 9, the downside momentum may begin to fade as the S&P 500 nears the 20% level that marked the full extent of the 1990 and 1998 declines, S&P 500 valuations reach 17 year lows, and those sectors most affected like fi nancials experience peak-to-trough declines of nearly 40%. While the market trough may still be ahead, it is important to try to keep in mind a longer term outlook. Since WWII there have been 16 market declines of around the current magnitude of 14% or more. On average, 12 months after hitting the trough stocks were up 32%.
This report has been prepared by LPL Financial from sources believed to be reliable but no guarantee can be made as to its accuracy or completeness. The opinions expressed herein are for general information only, are subject to change without notice, and are not intended to provide specifi c advice or recommendations for any individuals. Please contact your advisor with any questions regarding this report.
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