Does the Recent Market Weakness Predict a Recession?

Throughout financial history, analysts have looked at the performance of the stock market as a leading indicator for the economy. While it is true that a strong stock market generally means the economy is strong, market weakness does not always indicate a recession is on the way.  Indeed, an old stock market adage is that stock market corrections have predicted 9 of the last 2 recessions! History certainly suggests this is true in some instances. For example, the crash of 1987 had no economic significance, although it was scary for market participants.

The recent correction in stocks has raised questions regarding the strength of global growth - will there be a significant slowdown or not? We believe there will not be a slowdown, and will analyze the SPY (S&P 500 ETF) to support our conclusion. Examination of the chart of the SPY shows the recent correction has made a double bottom at the same correction low of late January/early February 2010, as we have drawn on the chart below. This is basic Technical Analysis, but it is not the end of the story. We use Sector Analysis to take an "X-ray view" of market action.

Below is a chart of the XLY (Consumer Discretionary sector ETF), and notice out how much higher the recent low is compared to February 2010. This relative out-performance of the XLY vs. the SPY suggests the consumer remains strong.

Technology (we use the IYW as it is a pure Tech play, rather than the XLK, as it combines Tech and Telecom) is another strong sector.

Where is the weakness? Two weak areas are the XLV (Healthcare ETF) and the XLE (Energy ETF).  Both of these ETF's have moved below the February 2010 lows. Possible reasons for a weak XLV is confusion regarding earnings visibility due to recent legislation in the form of the Healthcare Reform Bill.

Issues surrounding BP and the Oil spill in the Gulf could account for weakness in the XLE.

Looking at stocks in the sectors confirms these views. MCD and AAPL are strong charts in favorable sectors, while PFE and APC are obviously weaker.