The Santa Claus rally lost its legs this week, after the S&P dropped 4.5%. Technically, however, the uptrend that began in December is still intact–on both a daily and weekly basis. This week’s slump wasn’t big enough to break it. But another significant decline next week, if it happens, could do it.
The week’s economic data was dominated by jobs, more to the point, job losses. The unemployment rate spiked to 7.2% (the highest since 1993) and December nonfarm payrolls lost 524,000 jobs. Almost lost in the background were miserable reports on December auto sales, factory orders, pending home sales, and consumer credit.
For the current uptrend to march on, investors will have to continue to shake off this never ending bombardment of bad news. Some short-term traders are looking for a psychological lift from the Obama inauguration to maintain upward pressure on prices. Will this work? We’ll see. But it’s safe to say that the traders will be the first to run for the exits if the uptrend fades.
Many investment pros are still waiting on the sidelines with lots of cash, looking for some signal that the ongoing global economic collapse is at least showing signs of decelerating. Today, no such signal exists. This suggests that the equity markets will not rally sharply in the near term. The more plausible scenarios are: 1) rangebound or sideways action, or 2) another leg down if corporate outlooks disappoint and the economy continues to slide in the face of existing monetary stimulus and upcoming fiscal stimulus.
How likely is the economy to continue to suffer? And how much further could it slide? Kenneth Rogoff and Carmen Reinhart, studying asset and credit busts over the last 100+ years, uncovered some bad news. On average, housing prices fall 36% (peak to trough) in real terms (perhaps more in nominal terms) and take 5 years to do so. Equity prices fall 56%, taking 3.4 years to get there. Unemployment rises 7% over 5 years and GDP contracts by over 9% (per person) over 2 years.
This suggests that we might be far from seeing the worst of the crisis. Housing can fall another 15+% from peak; equity prices, another 15+% from peak; unemployment could reach 11-12%; and GDP could plunge another 8%, from here.
If anything like this happens, then the monetary and fiscal stimulus that today’s equity prices depend on would have failed. Unfortunately, history suggests–strongly–that this can occur.
Almost all leading economists are admitting that there is no guarantee that the current monetary and proposed fiscal programs will work. What’s even more scary is that there is no Plan B.
That means that there is a reasonable possibility that the U.S. and global GDP shrink by 5- 10%, or more. To say that this would put the entire system of capitalism at risk would be an understatement. In this scenario, the continuation of the bear market would be the least of our problems.