The S&P 500 suffered a drop of more than 22 points Monday, closing at levels not seen since the end of May. Is this significant? Maybe, but it is not significant in and of itself.
One day does not a trend make. One significant number for the 2.3% drop in the S&P was the volume, the second lowest since the March 9 bottom.
There did not appear to be a rush to take profits after the big rally. It was more like a case of boredom allowing the market to just fall through inattention. The follow-through trading for the rest of the week will determine if Monday's decline has significance. (The S&P closed down 11.75 points on Tuesday.)
Last week, a number of
commentators expressed bearish opinions on the near-term prospects for the U.S. stock markets. Among those weighing in were Helene Meisler, Dick Arms, Doug Kass, Vincent Farrell and myself. This morning, an explosion of negative postings and publications was noted around the world. Some of these are discussed here.
From London, Wolfgang Munchau, writing in the
, discusses a research paper by
Eichengreen and O'Rourke compare the state of the world economy in 2009 to 1930's. They imply (it is not directly stated) the question: Can anything be done to prevent an economic path continuing to run parallel to the earlier course all the way to a bottom equivalent to 1932? This draft does not directly answer the question, but the implied answer (to the implied question) is at least "maybe," and possibly "yes." They conclude the current draft of the paper with the following paragraph:
To summarize: The world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-1930. Looking just at the U.S. leads one to overlook how alarming the current situation is even in comparison with 1929-1930. The good news, of course, is that the policy response is very different. The question now is whether that policy response will work.
The conclusion I take from this excellent paper is the opinion that correct policy actions (which have been started), if continued, can arrest the global decline. It is clear that they are not arguing that a recovery is near, just that the decline can be slowed and stopped without going all the way to a 1932-like condition in 2011.
The essence of the Eichengreen and O'Rourke analysis contradicts the idea of a 2009 recovery. They do not yet discuss a projected bottom to the current economic decline (a bottom must precede a recovery), and nothing they have done to date would indicate they will project a bottom in global economic activity in 2009.
article in The Financial Times
reports Chinese Premier Wen Jibao is cautioning about "the durability of economic recovery in the world's third-largest economy." The Chinese concern is centered on the continued decline in worldwide demand for Chinese exports.
, the drastic collapse of production in Japan has been reported:
"Overall industrial production in Japan fell 22.1% in the January-March period from the previous quarter, and Japan's government announced earlier in the week that it forecasts a shrink in industrial output by a record 23.4% in the fiscal year, which started April 1."
In the same article, government projections that as much as 10% of this may be recovered this quarter were reported. If that were to occur, it would indicate that the global economic decline was ending, since Japan's industrial production, like China's, is export- driven. It seems likely that either the Japanese government projections are too optimistic or the Chinese pessimism is overdone.
Last week, a report from Japan indicated the error was in Japanese optimism. It was reported on June 10 in
"Core machinery orders -- a key gauge of business activity -- fell 5.4% month-on-month in April, far worse than the average forecast of a 0.8% increase. Meanwhile, Japanese wholesale prices dived 5.4% in May from a year earlier -- the biggest drop since March 1987, when prices also tumbled 5.4% -- and worse than a market forecast of a 5.1% fall."
This is a direct contradiction to the previous projections of second-quarter growth. It also indicates the deflationary spiral that has engulfed the Japanese economy for much of the past 18 years has still not been arrested.
Bank of Japan made a statement Monday indicating that it saw a slowing of the Japanese economic decline in the second quarter. According to the
, after a meeting of its policy board, the Bank of Japan said, "Japan's economic conditions, after deteriorating significantly, have begun to stop worsening. In the coming months, Japan's economy is likely to show clearer evidence of leveling out over time."This trichotomy of news items is typical of the situation investors face near possible inflection points. The three elements are: (1) current data is still negative; (2) the cheerleaders, in this case the Japanese government, are trying to anticipate the other side of the valley, the recovery, often prematurely; and (3) the analysts, in this case the Bank of Japan, are trying to measure the rates of change (second derivatives) that must occur before the inflection point that will mark the bottom of recession. Investors fall in the third category.
Martin Hutchinson, writing today in
, presents a detailed argument that the current rally has been in the context of a secular bear market, which has yet to reach its ultimate bottom.
Another bearish opinion comes from Guy Lerner at
Dumb Money Indicator
has surged to a high much above anything seen since 2006. While he is not ready to declare a bearish trading position, I am taking due note of an indicator warning. The
Dumb Money Indicator
has been a reliable contrary indicator (high bullish reading preceding market declines).
Michael Patterson, reporting for
last week, said that professional investors were becoming more bearish. This is in agreement with Guy Lerner's
Smart Money Indicator
, which was on the verge of issuing a bearish signal as of Friday's close. And, of course, we have the increase in bearish opinion last week right here on
, as noted in the second paragraph.
What Should Investors Do?Investors are trying to analyze the situation on the horizon, just as the Bank of Japan is doing in the earlier report. That is why stock market bottoms usually occur several months before recessionary contractions end. These rallies in recessions are usually correct in anticipating the end of the contraction, but occasionally they are false signals. Examples occurred with the 43-month recession that started the Great Depression. During the secular bear market that bottomed in July 1932, there were four primary bull markets (primary bulls defined by gains of 20% or more) before the final bottom. The largest of these was the first of the four, which rose 48% from Nov. 13, 1929, to April 17, 1930.Because of the severity of the current worldwide contraction, far worse than anything in 60 years, some have been trying to make comparison to the 1930s time frame, such as in the Eichengreen and O'Rourke paper. This produces comparisons of the current rally to the 48% advance that topped out in April 1930. The question that all investors should be trying to answer is whether or not the economic and market patterns will now diverge from the 1929-1930 pattern. And, if there is divergence, exactly what is the shape? Is it like the patterns of the two previous severe recessions (1973-74 and 1981-82) or will it be less upwards and more sideways, the so-called L-recovery?
Many economic metrics, such as GDP decline, many unemployment statistics, and worldwide manufacturing decline, are significantly worse than for the two other severe recessions. This means that modeling the incipient recovery here on these two previous recessions can be questioned. Likewise, the nature of the world in 2009 is far different from 1930, so modeling the next couple of years on the 1931-32 pattern is also suspect. We come right back to the L-shaped recovery (a contraction followed by a long, broad bottom with little economic growth) as a default compromise.
It remains to be seen whether or not the recovery will be strong enough to support the prices reached in the recent rally. Looking around the world, it seems this is a time to be prudent and keep some powder dry. The number of negative things emerging in the past several days could have negative effects on U.S. equities. The more adventurous may want to increase short positions in stock indices, such as the S&P 500 and the Nasdaq 100.
John B. Lounsbury is a financial planner and investment adviser, providing comprehensive financial planning and investment advisory services to a select group of families on a fee-only basis. He worked for 34 years with IBM, and spent 25 years in R&D management and corporate staff positions. He also was a Series 6, 7, 63 licensed representative with a major insurance company brokerage for nine years.
Specific interests include political and economic history and investment strategy analysis. He holds degrees from the University of Vermont, Columbia University and the Illinois Institute of Technology, where he studied chemistry, physics and mathematics. He is a contributor to Seeking Alpha and his own blog,