Anthony Mirhaydari
Investors felt the burning tinge of panic over the past few weeks as the stock market suffered some of the most dramatic drops in history. By one measure, equities dropped with a ferocity not seen since the 1940s.
Small caps were among the hardest hit, losing more than 20% -- qualifying them for bear market status. The big-cap Standard & Poor's 500 Index ($INX) has completed a "death cross," an ominous term chartists use to describe a downward cross of the 50-day and 200-day moving averages.
Many investors, numb from all they've endured over the past four years, threw their hands up in despair. Mutual funds recorded massive withdrawals as they pulled their money out of the market. Consumer sentiment, as recorded by the University of Michigan, dropped to its lowest level since the data was first recorded in the 1950s.
As I described in "Can anyone fix this economy?", a combination of economic vulnerability, policy bungles and unintended consequences have sapped the strength and optimism developing in the wake of the springtime energy price spike and Japanese disaster.
This fear threatens to pull an already weakened economy -- trudging along with unhealed wounds like 9%-plus unemployment and a dilapidated housing market -- down into a double-dip recession.
If that happens, the logic goes, we'll face a protracted downturn because we have few tools left to resuscitate growth. Given the economic imbalances, excess debt and pure desperation out there -- represented by record long-term unemployment and a record number of Americans relying on food stamps -- it could very well be Great Depression 2.0.
But our fate is not sealed. In fact, there is evidence that savvy Wall Street pros are already playing for a turn, snapping up shares jettisoned by the average investor at a loss with the intent of demanding top dollar later. The actions of those savvy investors suggest that this a temporary slowdown à la 2003, 1998 and 1995 -- all of which marked fantastic buying opportunities.
That's helped stocks push off their lows and move higher after last week's violent, up-and-down swings. The S&P 500 has already regained nearly 8%.
Here's why this do-or-die moment may see the market keep going up -- and how you can ride along with it.
Stocks priced for a dark future
I've hammered away at all that's wrong in my recent columns and blog posts, so I won't repeat myself. Just know that the situation is tenuous. Washington is dysfunctional. Europe, with its imperfect monetary union, is in purgatory. And the United States is trying to reorient itself as a responsible export-led economy but is going about it the wrong way.
The reason the economy is on the brink is that growth in the first half of the year averaged a pitiful 0.8% annual rate. That's well below "stall speed" of around 2% -- the level needed to keep unemployment from rising.
Operating below stall speed also pushes down prices, which makes the problem worse: Lower prices erode corporate confidence and cause consumers to withhold spending, further damaging the economy and lowering prices. It's a negative-feedback loop that throughout history has threatened to pull our economy, whenever it ventured into the sub-2% doldrums, into outright recession.
And now, we have a crisis of confidence that threatens to keep shoppers out of stores and corporate executives from hiring. No wonder the yield on the 10-year Treasury note has dropped all the way down to 2.3% -- a level just off the lows hit in the panic days of late 2008. To put it simply, the bond market is pricing in a deflationary recession.
So is the stock market. David Bianco at Merrill Lynch finds that, based on long-run price-to-earnings comparisons, stocks are trading at levels consistent with a mild recession featuring a 20% drop in earnings and a 2% contraction in the U.S. economy. Depressed valuations have pushed the "equity risk premium" -- the theoretical profit cushion offered to nervous investors for buying stocks over Treasury bonds -- to an all-time high after swelling to levels not seen since the early 1980s.
Overseas markets are also pricing in a dark outlook, according to Credit Suisse. Russian equities are anticipating crude oil falling to $70 a barrel from $88 now. Turkish banks are priced for downward earnings revisions of 17%. South African industrial stocks are priced at a level typically associated with an outright contraction in U.S. factory output. Polish stocks are priced at a level consistent with a 21% drop in German capital goods orders.
I think this bleak outlook has gone too far.
Green shoots of growth
While the economic data have been disappointing, we haven't seen a complete washout.
The ISM manufacturing index, while well off its highs, isn't yet in recessionary territory and remains consistent with 5% earnings growth, according to Merrill Lynch. Core retail sales have been better than expected. Auto sales are strong. Vehicle production is ramping up. Steel output is rising. Initial jobless claims have dropped to levels not seen in months. And interbank lending rates remain low.
There's been good news for consumers, too. Banks are finally loosening credit standards. Loan activity is rising as demand for consumer loans swells for the first time since 2005. Energy prices are falling. Home prices are rising. More high-quality, high-wage jobs are being created. Household incomes jumped 3.5% in the three months through July.
Profits have been strong despite economic head winds. With the second-quarter earnings season nearly wrapped up, S&P 500 companies have reported earnings-per-share growth of 21% over last year, compared with a 15% estimate at the start of the season. Sales growth clocked in at 15% versus 8% at the start. Typically, profit growth turns negative before a new recession.
