December 6, 2008

The S&P500 ended the week down about 2%.  But the equity markets displayed massive intra-day volatility, often trading up and down 2+% in the same session.  The bear market continues, on a long-term basis.  However, the equity markets seem to want to climb in the short-term. 

Despite suffering through an onslaught of horrible economic data, the equity markets held up amazingly well.  They shrugged off plunging home sales, durable goods, personal spending, auto & retail sales, ISM services, consumer credit and payrolls data.  Especially after the payrolls data (loss of 533,000 jobs), it’s not an exaggeration to state that the U.S. economy is falling off a cliff.   Capital is fleeing to treasuries driving down yields to levels not seen in decades.  Corporate and municipal credit spreads remain high.  Corporate earnings guidance continues to sink.  And layoff announcements are soaring. 

But don’t tell that to the equity markets!  Our economic and credit disasters, according to equity investors, are already discounted in the current equity prices.  This is creating another massive divergence.  The fundamentals are falling apart, yet technically, the market seems to be forming a bottom–at least in the short-term.   Many are calling this the technical bounce from deeply oversold levels.  OK, but be careful!  On several occasions earlier in 2008, the equity markets day-dreamed their way up, temporarily, only to be rudely awakened by the grim reality of the economic and corporate data.  The problem this time:  never in 2008 have the economic data been more negative than during this past week.  It’s getting very ugly and very scary.

The fourth and final quarter of 2008 is almost over.  Look for many more earnings reductions in the form of guidance and actual misses from lowered guidance.  Look for more layoff announcements.  Look for credit defaults to rise–about a trillion dollars of U.S. corporate debt needs to be refinanced in 2009; more and more of it will not get rolled over.  If equity gets raised to replace it, stockholders will get crushed. 

The federal government is intervening on a massive scale to prop up the credit markets, and eventually–through fiscal stimulus–to prop up aggregate demand.  But the government will most likely not be able to replace, in it’s entirety, the implosion in the private sector.  It appears that aggegate demand is collapsing, resulting in a severe recession where deflation will become the enemy to fight.  But as in Japan in the 1980’s and the U.S. in the 1920’s, we will be fighting a massive deleveraging process (stemming from the bursting of the housing bubble) that can overwhelm the best efforts of the U.S. government.  No matter what the government does, it cannot force consumers or corporations to spend.  And it can’t fully replace that spending itself.   So the outcome, unfortunately is looking like it will resemble the deep and prolonged recessions of the U.S. in the 1930’s and Japan in the 1990’s. 

Perhaps the U.S. equity markets will agree, eventually.  Unless the bottom in the economic cycle is visible–even six to nine months from now–then the bottom in the equity markets has not been established.  The pain is not over, not by a long shot.

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