Economy Tanking, Stocks at a Crossroads

The S&P500 fell for the fifth consecutive week, this time dropping 2.3%.  The volume was light, but part of that can be explained by the holiday shortened week, rather than the lack of conviction behind the selling.  Volatility turned back up, investors took notice, asking if the recent downtrend is simply another buying opportunity, or the beginning of a stronger and deeper wave of selling.

What sparked the selling was the undeniably horrible economic news.  There is very little doubt that the US economy is turning down.  The main question is whether it’s merely entering a short-lived soft patch or if it’s falling into a double-dip recession.

Housing, no doubt, is double-dipping.  Case-Shiller printed home prices that were much worse than expected; the 20 city index reached new post-bubble lows in much of the nation.  Chicago PMI collapsed, when it was expected to simply slip a bit.  The critically important ISM Manufacturing index (because it’s one of the best leading indicators of cyclical turns in the economy) plunged to the lowest level since September 2009. Initial jobless claims, also a key leading indicator, disappointed again with a 422,000 print, which was also worse than expected.  Factory orders also sank.  And finally, May’s jobs report was horrendously bad.  While expert economists were busy slashing their prior estimates, the 54,000 jobs number was far worse than the revised consensus estimate.  The headline unemployment rate also rose to 9.1%, when it was expected to fall to 8.9%.  What’s worse, the government’s magical Birth/Death model conjured up 206,000 jobs as part of the headline results. While this 206,000 figure can’t simply be subtracted from the 54,000 (due to season adjustment differences), a big chunk of the can be set aside.  So if even only 150,000 of the concocted 206,000 Birth/Death jobs are subtracted, then the economy really lost about 100,000 jobs in May!  And this is supposed to be a recovery?

Technically, the S&P is at a crossroads.  Ever since QE2 was pre-announced by Ben Bernanke in late August 2010, the S&P has always bounced back up from a multi-week correction right about ……… now.  This means, that if the S&P doesn’t move back up above its 50 day moving average by the end of next week, then a lot of traders might start running for cover—to protect the profits that they’ve made over the last 9 months.

If so, there’s a lot of air between last week’s 1,300 closing level and support at the 1,250 level which is the 200 day moving average.  See the chart below.

The good news for the bulls is that the S&P has only lost about 5% from its April peak. That’s not a lot of damage for five straight weeks of losses.  With respect to the economy, the bulls will look for the downturn to be no less severe than a temporary soft patch, one that gets brushed off quickly and replaced with more robust 3%+ GDP growth in the third and fourth quarters of this year.

But the bears have several major forces on their side.  Just as the economy was about to double dip in the summer of last year, the Fed ran to the rescue with QE2, which sent the stock markets soaring in September.  To add to the Fed’s monetary stimulus, the Congress added several fiscal boosts in December of that same year, notably the temporary reduction in Social Security taxes, the extension of the Bush tax cuts, and the extension of the emergency unemployment benefits.

Most of these positive forces are about to expire.  Most importantly, QE2 ends in a couple of weeks.  On the fiscal front, there’s very little doubt that stimulus will be dropping off over the second half of 2011 and into the foreseeable future after that.  The Democrats and the Republicans are under tremendous pressure to reduce the deficit (from its insanely unsustainable $1.5 trillion per year level), and the only question is how much spending they cut and how soon.  Taxes may also rise.  Both—spending cuts and tax hikes—will not only remove stimulus from the economy, but they will create outright headwinds to future growth.

So there’s very little doubt that the economy is facing some tough times ahead.  The more open question is whether the stock market will follow the economy down, or will it continue ignoring the warning signals…..for a while longer.


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