The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.NEW YORK ( TheStreet) -- On Friday, the Labor Department said U.S. payrolls were unchanged last month. This was the weakest reading since September 2010 and worse than economists' forecasts. The weak reading on jobs weighed on stocks as market participants reacted to fears of a recession. The stock market's sharp 2.5% decline on Friday left the S&P 500 down -0.2% for the week, making last week the fifth of the past six weeks that the stock market suffered a loss. We continue to believe that, rather than recession, weak economic growth will continue this year. However, in recent weeks, markets have moved to fully price in an impending recession.
If we assume recession EPS of $83.85 and multiply that by the average recession PE of 13.35, we get a recession level of about 1120 for the S&P 500, which is exactly where it bottomed out three times during the past month. It is no wonder that during August the stock market fully priced in a recession as events took place that included:
The debt ceiling debacle U.S. credit rating downgrade Worsening European debt problems Riots in London The worst month for U.S. casualties in Afghanistan Plunging consumer confidence readings All of these combined to drive the stock market down 18% from the peak that took place back in April of this year. Investors may not need to worry about the impact of a recession since it already appears to be fully priced in to both stocks and bonds. It is not unusual for the stock market to fully price in a recession well before it has ended or even before it has been declared. Over the past 50 years, the stock market has typically bottomed three to six months before the low point of the recession. In addition, there have been times when the stock market fell and priced in a recession that did not take place, such as the bear markets of 1987 and 1998. It seems that the debate over whether a recession will take place has now been settled for many investors and they have moved on to whether the recession will be much worse than average. Based on this analysis, a much worse-than-average recession could drive EPS down 22% to $74.32. In that event, the S&P 500 Index may suffer a greater decline to about 1000, which would mark a peak-to-trough market decline of a hefty 36% from the recent high of 1363. We see this as a very low probability. Despite the worries over the weak August job report, it is important to remember that just one month ago (the July 2011 report released in early August) the jobs report was much stronger than expected. As we have been saying all year, volatility in the economic data is to be expected. While sentiment readings were weak, economic data during the month of August was positive solid and pointed to continued slow growth. These key reports included: industrial production, retail sales, durable goods orders, shipping traffic, business lending, initial jobless claims, corporate earnings reports, and both the manufacturing and non-manufacturing ISM indices.
We see more upside than downside to the stock market. Our base case remains, as it has all year, for stocks to post modest, single-digit gains in 2011 which suggests about a 15% gain from current levels. A recession, the odds of which we peg at about a 1-in-3 chance of taking place, may mean that stocks revert back to the August lows of 1120 and suffer a 5% decline from the closing level on Friday, Sept. 2. And we see a very low, but not zero, probability of a deep recession that may pull stocks down another 15% from current levels. The markets' obsession with recession does not make it a foregone conclusion. Investors' lack of confidence in economic growth, corporate profit forecasts, and the actions of policymakers is likely already fully reflected in the markets and creates the potential for a bounce if any of them exceed low expectations. Like we said as the market made the lows of August: the stock market climbs a wall of worry not when risks go away, but when the confidence that they will be overcome returns.