Feature Stories | Jul 22 2009
(This story was originally published on July 14, 2009. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).
By Greg Peel
On the day of publication of this article, stock markets are enjoying a US-led interim bounce. But this may yet prove a blip in a market that otherwise seems to have lost its way, and lost its earlier confidence. Did we simply become prematurely enthusiastic over the last few months?
The 2002 Experience
Throughout the progression of the current economic downturn from mid-2007 to now, economists have chopped and changed and reassessed which previous downturn this one could best be compared to. In mid-2007, the then “subprime crisis” was not expected by the majority to cause anything much more than a blip. By late 2008 the expression “Global Financial Crisis” had been accepted and immediate comparisons were made with the 1930s.
It suits politicians to maintain such sensationalism, because it provides justification not only for resultant policy, but for any policy failure. Economists in general have since (notwithstanding a remaining school of uber-bears) pointed out that the Crash of ’29 eventually led to The Great Depression because governments and central banks of the day did everything wrong and nothing right in response. Monetary policy was tightened instead of eased, massive institutional failure was accepted with a shrug and no fiscal stimulus was provided at a time when there were no unemployment benefits.
Bank analysts in Australia had initially used the 2002 recession as a benchmark for just what level bad debts might reach this time, for no other reason than this was the only recession to appear on ten-year data. But for Australia the 2002 recession was rather mild given we had no rampant tech sector that needed correcting. Soon it was clear the 1992 recession was a more realistic benchmark to work from.
The 1992 recession provided other parallels, as the Savings & Loan crisis in the US at the beginning of the nineties provided comparisons of what happens when an economic downturn is rooted in the financial sector. However, economists were also looking back further in time to the seventies for a possible repeat of runaway inflation, or at the very least a comparison of what happens to a global economy when the oil price runs riot. Most recently this has led to the 1982 recession as perhaps being the right historical benchmark to choose – deeper than 1992 but not a Depression.
The reason for seeking historical precedence in recessionary comparisons is to hopefully provide guidance as to just how long it will take to come out of recession. Stock markets are supposed to be a leading indicator of economic performance, so does the “green shoot” rally of 40% on the US S&P 500 in particular fit in with past experiences and if so, have we seen the bottom now? Or might the current dissipation of momentum imply the bottom yet remains elusive? What does history tell us?
Respected chief economist and strategist with Canada-based Gluskin Sheff, David A. Rosenberg, suggests simply “We have seen this movie before”. The trailer voice-over goes something like this:
“A recession dominated by asset deflation, widespread excess capacity and deflation pressures, and then a huge shock that drags the equity market to massively oversold lows. Fiscal and monetary stimulus then ramp up, hopes of a capital spending revival and inventory restocking spring eternal, and risk assets enjoy a significant multi-month rally as earnings and economic projections get revised higher by the consensus community.”
Rosenberg then draws upon legendary former Merrill Lynch strategist Bob Farrell’s Ten Market Rules To Remember (available in FNArena’s Take Note section). Rule 8 states:
“Bear markets have three stages: (1) sharp down; (2) reflexive rebound; (3) a long term fundamental downtrend.”
The bad news is that we have so far completed only (1) and (2). Rosenberg actually suggests what we have seen so far in the 2007-09 episode is similar to what occurred in 2000-03, to bring us back to our original and most recently experienced recession template. We recall that having individually suffered both the tech-wreck and 9/11, the impact in the US was much greater than that which reverberated into Australia.
The S&P 500 reached 1520 in September 2000 before the tech bubble burst. By September 21, 2001 – ten days after the 9/11 attack – the index had hit 965 (sharp down). It then bottomed and reached 1170 by March 2002 (reflexive rebound) before momentum faded and the ultimate bottom proved to be 776 in October 2002. But that was the lowest point of a triple-bottom formation, and the subsequent bull market began off the final low in March 2003 (drawn out fundamental downtrend).
The S&P reached 1565 in October 2007 and then 676 in March 2009 (sharp down). It bounced to 946 in June (reflexive rebound) but now has drifted off again. What comes next?
The 2002 recession was also one of asset deflation, and Rosenberg suggests what we are currently experiencing is “eerily similar”. However this time around deflation pressures are “far more acute even with the dramatic government efforts to stem the tide” and this time around the cycle isn’t “solely dominated by asset deflation but a cycle that was also defined by the end of a secular credit expansion”. In other words, 2002 saw an asset deflation episode within a wider cycle of massive credit expansion over the past decades.
Does this mean we are in for an even longer “long term fundamental downtrend” ahead?
It is important to realise that the end of a recession does not immediately imply the beginning of the next bull market. It is one thing to arrest economic contraction. It is another to return to healthy economic growth. History suggests, notes Rosenberg, that in the aftermath of a bubble-and-bust it takes an unusually long time to embark on the next sustainable expansion – with emphasis on the word “sustainable”.
One might care to note that on the wider scale of things, the post WWII bull market ended in the sixties but the next bull market did not establish itself until the early eighties. This was a supply-side recession however, featuring oil shocks which pushed inflation to double digits, trade union power which kept it there, and central bank monetary policy which to that point didn’t see a need to control inflation. Central banks have since learned to control price inflation, but not asset inflation. Thus the 1992 recession was rescued by the tech bubble and the 2002 recession was rescued by the housing bubble and the China bubble.
In other words, if the US posts a positive quarter of GDP in maybe the June or September quarters, we should not immediately assume the recession is dead and the next bull market is upon us. However, there is plenty of faith at present for an end to the US recession given the positive prospects of an inventory restocking phase. Recessions used to be drawn out by inventory overhang when retailers and wholesalers were caught with stock they couldn’t sell. Now that inventory management has become far more efficient in the computer age, US companies were very quick in getting rid of stock once the GFC hit in earnest. This means inventories now have to be restocked, and the hope is such restocking will provide the economy with the stimulus it needs to actually turn around rather than just stop contracting.
This is all well and good, but at the end of the day someone still has to buy that stock from the retailer. If the June quarter GDP is positive for the US, it must be noted that recently released June chain store sales data and auto sales data have come in well below expectation. The fear, suggests Rosenberg, is that by the fourth quarter there will be an economic relapse, and that’s not what the stock market is presently pricing in.
“If the lesson from the 2000-02 cycle is any indication,” Rosenberg offers, “calling for the recession to end is basically irrelevant. What matters is that the recession’s end gives way to a vigorous expansion, which is typical in a classic inventory-induced cycle. But in an asset and credit cycle, there is generally an elongated period where the economy is no longer contracting but neither is it growing anywhere near its potential even after the recession is officially terminated.” (My emphasis)
A common-or-garden recession features inventory overhang and lasts on average 10 months. Monetary and fiscal stimulus are then implemented and ultimately achieve their goal, sparking an average 20% stock market rally in the next twelve months from a “V” bounce as recovery is priced in. The current recession is already 20 months old, and the “V” is topping out and threatening to become a “W”.
Current monetary and fiscal stimulus is, at this stage, achieving only a prop to the market allowing balance sheets to be rapidly repaired following the bursting of the credit bubble. In the meantime, excess production capacity (idle factories) and excess labour (unemployment) continue to build and corporate pricing power continues to wane. Thus while the recession may technically end, the market cannot actually return to strength until the next clear sustainable growth cycle. The economic recession of 2001 (negative GDP) actually ended in November 2001, but unemployment continued to rise for 20 months and capacity utilisation did not turn around until well into 2003. Only when economic growth became sufficient to begin absorbing excess capacity did the next bull market phase begin.
But even in that instance, Rosenberg points out, significant stimulus was provided by then Fed chairman Alan Greenspan dropping the US cash rate to an historically low 1% in (what even he now considers) an over-zealous response to the impact of 9/11-based fear coming on top of the tech-wreck. This provided the base for the housing bubble and for Americans to buy (on credit) everything China could throw at them. In turn, China needed to suck up the world’s resources in order to satisfy US (and European and elsewhere) demand.
At the same time, the Bush Administration attempted to whip Americans into a patriotic fervour of buy, buy, buy in order to show those evil terrorists the mighty US economy would not bow down. The only problem is, Americans were supposed to buy Chevrolets and not Toyotas and General Electric whitegoods and not those from Lucky Golden Trading Company. And even then, it took two years in limbo before the stock market responded to the end of the recession and the beginning of the next bull market. The market view had previously been that an inventory rebuild would drag the US quickly out of the post 9/11 recession.
This bar chart shows how US GDP performed over the period:
Now compare to a graph of the S&P 500:
[Chart courtesy of eSignal]
We note the post 9/11, 2001, low which reached slightly below the previous major low in 1998 caused when hedge fund LTCM was rescued. This low followed a spiky but sharp down-phase before a reflexive rebound which pre-empted the turnaround in GDP in 2002, apparent in the graph above. But GDP growth struggled, and almost faltered in the fourth quarter 2002 before the effect of drastic monetary easing began to take hold. The S&P 500 lost its bottle in the second quarter, and crashed to a new low. It then oscillated in 2003 before finally being convinced of recovery.
Thus the end of the recession was a false signal for the stock market to immediately begin its next bull run. This was unusual, given most post war recessions were followed by a “V” bounce just before GDP turned, Rosenberg notes.
Rosenberg does not pay heed to the traditional “two quarters of consecutive negative growth” definition of recession, but rather he offers the US National Bureau of Economic Research measure as most appropriate. NBER uses four factors – production, employment, sales and personal income – as key in determining when an economy enters a recession, and when it comes out. In every US recession from 1961 to 1991, these four factors all bottom out within two months of each other. But in 2001, only production and sales had bottomed when NBER declared an end to the recession in November 2001. Personal income did not bottom until December 2002, and employment not until August 2003.
While NBER proved correct on a GDP basis, it was ultimately premature on its own measure. The stock market tells the tale. Corporate earnings did not recover along with GDP until two years later.
This time around, NBER announced in December 2008 that the US recession began in December 2007. It has not yet called an end to the recession. Rosenberg’s view is as follows:
“We will continue to say it – the end of the recession is not both a necessary and sufficient condition for shifting the asset mix in favour of risk assets. What hangs in the balance is the shape of the ensuing recovery – and it must be a complete recovery. From our lens, there is still no sign that we have reached that point where all four economic indicators have bottomed. Not even close, especially with respect to employment, production and income.”
All we have had are “green shoots”.
As we enter the next US quarterly earnings season and, shortly, the Australian FY09 reporting season, the respective stock markets are holding their breath. However, stock analysts already expect average US earnings to be a massive 36% lower for the quarter, and stock market reaction will be based around this forecast. In Australia, consensus expectation has FY09 earnings down 18% on FY08. The stock market has then predicted recovery, but in actual fact Australian consensus is for FY10 earnings to be 7% lower again.
The picture does not change until FY11, when consensus forecasts are predicting a 22% bounce. FNArena has now been emphasising this point for some time. Using FY11 earnings estimates, stocks are currently trading at low and attractive forward price to earnings ratios. Aside from the reality that much can change in two years, longer term investors can look to the longer term earnings forecast as a reason to buy at this level. However, the 2001-04 experience tells us that not only must longer term investors thus be patient, they may yet see lower entry levels. There is, however, no reason why 2009 must exactly mirror 2002.
We have examined a popular fundamental view. What are the technicians saying?
The Golden Cross
Late in June, many stock market technical analysts became very excited. They believed they had just witnessed a technically significant event – one that heralded the beginning of the next significant bull market. Chat sites and blogs have been alive with anticipation ever since. It’s all to do with something called the Golden Cross.
You’ll note from this three month chart that the S&P 500 (blue line) stumbled into June but bounced at the point where the red line crossed the green line. It did not subsequently hold onto this bounce, but for many technicians that is not important. All that is important is that the red line – being the 50-day moving average of the S&P 500 – crossed the green line – being the 200-day moving average. History suggests that such a crossover has occurred ahead of the beginning of most bull markets. It is thus called the Golden Cross.
Pension Pulse’s Leo Kolivakis notes that in the general scheme of things, the S&P 500 has on average added 12.6% one year following a GC. However, breaking down this number reveals a GC occurring during positive economic growth returns on average only 2.1% after a year, whereas a GC occurring in a recession returns on average 26.4%.
You can see why the technicians are excited. Fundamentalists scoff off course, and even the technical fraternity is at odds, with many suggesting the GC works better for the exponential moving averages rather than the simple moving averages, and more astute technicians use exponential moving averages, which haven’t yet crossed. (Kolivakis’ research actually challenges this argument.)
But technicians have another problem. While they might have just witnessed a significant GC event, the index has also been recently tracing out a classic head-and-shoulders pattern. Such a pattern is considered by the fraternity as another very powerful indicator, only this time in the negative.
If you take another look at the above graph, you’ll note from the low in the third week of May the index rallies to form a “shoulder” pattern, then rallies again to form the “head”, then drops down to an equivalent “shoulder” on the other side. One can draw a horizontal line across from the May low to the July low, and that is called the “neckline”. A breach of a neckline is a very bearish signal.
And lo and behold, last night on Wall Street (July 13) the S&P 500 bounced straight off the neckline, and surged ahead in a bank sector inspired intra-day rally. This might be enough to give the Golden Cross worshippers heart, and the courage of their convictions, and perhaps spur the general market back into rally mode. But one important factor must be considered.
While a Golden Cross may signal a positive result after a twelve months, it by no means rules out a big drop occurring beforehand. In other words, the GC does not rule out a “W” pattern and potential retest of the March low.
And if you think 26.4% in a year is a good return, well you should – historically it’s a great return. But the S&P 500 rallied 40% from March to July with no Golden Anythings to provide forewarning. Maybe those wishing to be bullish might take heart in that moving average crosses work both ways – bullish or bearish – depending on whether the 50-day moving average is rising or falling to cross the 200-day. Take a look at the five year chart:
Note that the two averages kiss a couple of times in the bull market, but do not meaningfully cross over until late 2007.
Spooky.
Also note that the 50-day moving average for the Dow Jones Industrial Average has now again crossed the 200-day moving average to the downside again. This is the opposite of a Golden Cross and widely known as a Black Cross, with supposedly negative longer term consequences. As at 14 July 2009 this has not yet occurred for the S&P500 or the Nasdaq indices.
We’ll allow Bob Farrell to have the last word, via Rule 9 of his Market Rules To Remember:
“When all the experts and forecasts agree, something else is going to happen.”
(If you read this story through a third part channel it may be that you are unable to see the charts and graphs included. Our apologies for this).
