What's Going On In The Markets, Vol. III

From 1960 through 2006 the odds of stock returns being positive in the 4th quarter were 78% and the average return was 4.17%. This gives the 4th quarter the best odds and average returns of any quarter in the year.The strongest returns have come in 4th quarters where the economic backdrop is soft and the Fed is cutting interest rates. This, of course, is precisely the position we find ourselves in as we approach the 4th quarter of 2007. A slumping housing sector has weakened the overall economy and yesterday the Fed cut interest rates for the first time in four years.

One might wonder why a weak economy should be conducive to strong stock returns. Doesn’t such weakness threaten recession and thus pose a serious risk to stock prices?

There’s no doubt that a recession would be damaging to investors as corporate earnings would collapse, dragging stocks down with them. And that is a risk at this juncture. But that risk was reduced materially yesterday by the Fed’s decision to lower interest rates by half a percent. Strong exports and healthy corporate balance sheets reduce recessionary risks, offsetting some of the problems in the housing market.

We’ve argued for some time that our ace in the hole with regard to recession risks is the Fed’s ability to cut interest rates from their recent level of 5.25%. Lowering interest rates is one of the most powerful economic tools at the Fed’s disposal. Bernanke & Co. signaled clearly yesterday that they won’t be shy in using it.

And that’s why a soft economy in the fourth quarter is conducive to rising stock prices: Because it’s also conducive to the Fed lowering interest rates.

While we can expect the usual chorus to rehearse a litany of reasons why the Fed’s actions won’t work this time, history suggests the Fed will succeed in averting recession. If the Fed succeeds, corporate earnings will continue to rise. And that is what stocks are anticipating when they rise despite a weak economic backdrop.
As we noted during the market turmoil of August, what we’re seeing fits the typical pattern at this point in the economic cycle: Some economic crisis arises, the economy slows, the Fed cuts interest rates (in effect gunning the engine of the economy), recession is avoided and the stock market and economy recover (in that order).

This happened in 1985 and in 1995 and we believe the economy and stock market are following a similar script in 2007. The low in economic activity will likely register in the 4th quarter of 2007 with an economic recovery unfolding in 2008. That recovery should be anticipated by stock gains six to twelve months prior. And, indeed, we got a taste of this yesterday with the market’s largest one-day percentage gain in four years. Stay tuned.