The Weekly View: Psychology and Reality: Consolidation Likely
While the extreme nature of the sell-off in risk assets over the last two weeks was part of our contingency planning, its magnitude still surprised us. We must now assess what it means and whether it is excessive, or prescient. What is clear is that investors are increasingly convinced a developed-world recession is coming, and we think they are assigning it about a 70% probability. This probability is likely based off high yield spreads, Treasury yields and stock valuations. We currently disagree, and put the chance of recession at less than 50%.
David Fuller's view Rod Smyth and colleagues make a number of interesting points in
this issue which I commend to subscribers. These include a review of their Three
Rules for Investing.
What
about the important point concerning whether or not we see a developed-world
recession?
The recession
question really matters in my view, as it would mean still weaker GDP growth
on a global basis and therefore a sharper drop in corporate profits than analysts
are currently forecasting.
Stock
market historians, as I have mentioned before, will point out that when US GDP
is still growing, S&P 500 Index corrections are mostly confined to a 10
to 15 percent range. Other stock markets, being smaller, will usually have somewhat
larger corrections.
However,
during recessions the S&P's corrections are more likely to become statistical
bear markets in the 25 to 35 percent range, and sometimes more as we last saw
in 2008/9. To date, the S&P has fallen
just under 20 percent from this year's high on 2nd May.
I would
feel more optimistic about the chances of the US avoiding a recession if growth
economies were not still maintaining their monetary tightening bias, ensuring
that they experience at least growth recessions.
Markets
are known for their frequent overreactions, which is another way of saying that
investors are prone to over exuberance in bull trends and capitulation in downturns.
Nevertheless, to the extent that the stock market is a leading indicator, the
message is not encouraging.
This
can also become self-fulfilling if it makes everyone feel more cautious. I certainly
feel more cautious and I suspect that a number of you do as well. I think this
is resulting in more PER compression in line with the secular cycle of valuation
contraction in western stock markets. We have been talking about this secular
trend, which we last saw between 1967 and 1982, for over a decade and it is
not over.
The single
most positive development, in my opinion, is that short-term interest rates
in the USA and Europe remain historically low. However, this also means that
the Fed and ECB were unable to reload their interest rate guns, before the economic
downturn which we are currently experiencing.
Psychologically,
this makes it doubly important for central banks in growth economies to moderate
their tightening bias. They will, but possibly not in time to prevent the US
and more European economies from dipping into recession. Meanwhile, growth economies
remain concerned about commodity price inflation which is their major problem.
Lastly,
while Mr Bernanke remains Fed Chairman we cannot rule out the possibility (probability?)
of QE3, perhaps by another name, in which he could get the biggest bang from
his fiat buck by purchasing S&P 500 futures. Awareness of this possibility
should mitigate downside risk for the US stock market in the months ahead. Moreover,
the announcement of another asset buying programme would almost certainly trigger
a significant stock market recover, as we saw after QE2 was launched in August
2010.