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

Market Update: Recession should be avoided but the risk is there

November 2007

After a strong run, the market stalled in June as the full impact of problems in the mortgage securities market began to unfold. Financial stocks, about one-fifth of the overall market, fell more than 20% in value from the beginning of June through the first four trading days of November. The contagion did not immediately spread, evidenced by the over 10% rally in technology shares during the same period.

However, when a sector as big as financials suffers a major correction, it is difficult for the broad market to continue rising, and now even the market-leading tech stocks have stumbled on fears of an economic recession. Fortunately, many of the major financial players have disclosed their losses, and there is some hope for stabilization. Meanwhile, volatility has returned with a vengeance, as 2-3% daily price moves in market indices have become almost a commonplace. There is now no doubt that the housing bubble has burst, and with it we are seeing the financial stress that often accompanies a mid-cycle slowdown in the economy.

We have maintained all year that the US economy would slow as the lagged effects of two years of interest rate hikes by the Federal Reserve take hold. This appears to be happening. The end of Fed rate-hike cycles also tends to be followed by some financial crisis. In 1985 it was Illinois-Continental Bank. In 1995 it was the Mexican Peso crisis. In 2007 it’s sub-prime mortgages and collateralized debt obligations (CDOs). In each case Fed tightening causes a weak link in the economy to snap–a weak link caused earlier in the cycle by too-easy money.

Sometimes the financial crisis leads to recession; sometimes it doesn’t. In 1985 and 1995 the Fed lowered interest rates during the crisis and the economy recovered. We believe the odds are 2-in-3 the current financial crisis will resolve without sending the general economy into recession. Corporate earnings remain strong apart from problems in the financial services sector. Inflation is contained. Unemployment is low. Productivity is high. US exports are booming as a result of strong demand from developing economies and a weak US dollar. And the Fed has plenty of room to cut interest rates if need be to stimulate the economy.

If we’re right and the US economy slows but continues to expand, US stocks should perform well as they did in both 1985 and 1995. Bull markets end with high stock valuations and enthusiasm among investors–just the opposite of what we see in the markets today.