Don’s Outlook 8/12/2011
After reaching severely oversold levels this week and hitting another key support level, the stock market bounced up and down in volatile trading. Although the trading activity may remind investors of the financial crisis, the daily spread between highs and lows over a recent five-day trading period was only half as large. The severity of the slide, however, did rival those experienced in 2008. The silver lining is that whenever the market has reached these oversold levels in the past, it has historically been higher over the next six months.
Although one could argue that the downgrade of long-term U.S. government debt was not a surprise, the market’s reaction on Monday would indicate that the timing, in fact, may have been. All three main rating agencies had warned that the U.S. debt rating was on their watch lists with negative outlooks, but Standard & Poor’s was quite clear about what type of concerted policy action and spending cuts that it was looking for right off the bat. So, when Congress came up short with only $2.4 million in definitive cuts, and in the process displayed a strongly divided Congress unable to rise to the occasion, investors should have counted on a downgrade. But the fact that it came just one week after the debt-ceiling agreement, and that it capped a week of widespread equity selling, caught many off guard.
It is often difficult to extricate the real reason for a correction, especially when many factors are often converging to tilt the market in one direction or another. Last week, a combination of factors, including weaker economic data, the apparent end to fiscal stimulus, and the potential downgrade were all reasons enough for investors to become more cautious. But when trying to price-in an unprecedented market event—the act of losing what has been deemed a “risk free” asset for the past 70 years—it can be difficult to gauge the potential market reaction, which all at once must take into account anything from complex financial modeling to public reaction.
The good news, however, is that Treasuries are still the risk-free fixed-income asset of choice, at least based on this week’s trading activity. Even though the announcement came just as the 10-year Treasury yield had fallen to a nine-month low of 2.5%, investors came out Monday clamoring for safe haven assets and Treasuries, in particular. As we saw during the financial crisis in 2008, Treasury securities can maintain their safe-haven status even in extremely difficult times. Treasuries are viewed as high quality, and no other government bond market can match the size, liquidity, and transparency offered by the U.S. Therefore, governments and institutions alike will continue to turn to this market for their high-credit needs. Moreover, the U.S. boasts the largest economy in the world and still holds the world’s reserve currency.
Given the severity of the stock-market slide in recent weeks, investors of all stripes have turned bearish, and it would appear they are increasingly pricing in the chance of a recession. The advent of a double-dip recession would likely take the markets even lower from here, however; so with the help of research from Federated Investors, I thought it would be good to review some common recessionary signposts, none of which are flashing dire warnings just yet.
For one, the yield curve almost always inverts as early as 14 months prior to a recession, but the curve remains upward sloping even with the recent rally in Treasuries. Moreover, recessions are often induced by the Federal Reserve, once it moves toward a tightening bias. Yet the Fed has maintained a well-advertised campaign to keep interest rates near zero—even extending their commitment to 2013 in an announcement this week—as well as an expansive balance sheet in order to keep credit available and the economy well-supported. Unemployment also remains at elevated levels rather than entering a trough; this is not usually the case when the economy is shifting gears or signaling a recession.
The next few weeks could be pivotal in determining the direction of the market. Macroeconomic concerns need to subside, so that investors can focus on incoming economic data and assess whether corporate earnings can hold up again this quarter. If so, we are likely to find support at these levels and, given that valuations are attractive, the bull rally should continue.
