It was a stormy week in the market. The correction I’ve long anticipated, and the biggest one week loss since March 2003, materialized but the sky didn’t fall. The chart below puts the week in perspective.
Return Dow Ind S&P 500 NASDAQ
12 month 19.5% 15.5% 24.7%
Year-to-Date 6.4% 2.9% 6.1%
Feb. – Mar. correction -5.6% -5.6% -6.9%
From 2007 high -5.3% -6.1% -5.8%
Last week -4.2% -4.9% -4.7%
Any investor should be happy with the twelve month returns of the major indices. If we assume the market was undervalued in 2006 and reached fair value at the beginning of 2007, the year-to-date returns on the Dow and the NASDAQ are respectable. Corporate earnings are expected to grow by approximately 5% in 2007 (see Earnings Matter), so the Dow’s and the NASDAQ’s appreciation is marching in step. The S&P is lagging due to its exposure to homebuilders and financial intuitions. (Those of you who own sector funds, note the risk.)
Last week’s correction came about because of widening credit spreads and illiquidity in certain parts of the debt market. The Chrysler LBO debt couldn’t be sold, so the banks were forced to hold it, and securitizations, an offshoot of the subprime mortgage problem, were effected.
Significantly, the market’s psychology shifted. All the issues leading up to the correction have been known for months but the market chose to look at the glass as half full (see The Glass is Half Full and Half Empty) until last week. Strong Q2 GDP growth of 3.4% and low inflation numbers were ignored. So was the strong 6.4% growth in exports - which shows the competitiveness of US companies and the positive impact of a weak dollar. The market took a bearish position, focusing on the residential housing market – weak new home sales and a rising inventory of existing homes on the market – and consumer spending increasing by just 1.3%.
Risk abound. There could be a full-blown credit meltdown. (See The Perfect Storm.) The construction industry accounts for 1 out of 10 jobs. Further weakness in the residential market could lead to more layoffs. The price of oil could hit a record high this week, leading to further weakness in consumer spending. A declining residential market and increasing oil prices could bring on a recession.
I don’t think so. At least not right now. The circuit breakers worked well last week. Treasury rates fell as investors sought safety. The world is awash in dollars which it has to recycle through the US at some point and the global economy is strong, witness the aforementioned overseas sales growth by US companies. (Many of the largest US companies generate 50% or more of their sales overseas, which is one of the reasons why Big Cap stock funds have performed well). As a last resort, the Fed could step in and cut rates just as it did during the last credit crisis (Russia and Long Term Capital Management), ten years ago.
What do I expect for the upcoming week? A violate market which works its way lower. You’ll note form the chart above that the correction thus far has been less than the Chinese-market induced February – March correction. As painful as they are, the good news about corrections over the past twenty years is that they’ve been swift. The tests will be if the Dow can hold above 13,000 and the S&P above 1,450. These are psychological levels, nothing more, but psychology is a powerful short term driver of the market. I see the markets falling by less than 10% from their high of 2007 (a recessionary market correction would be 20%), so we’re more than halfway through the pain.
Whether this is a correction in a bull market or the harbinger of a recession depends upon upcoming economic news. Watch employment data, specifically, new job creation (not unemployment). Job creation is the canary in the coal mine. Negative job creation means a recession is on the way. A second indicator will be a downturn in the commercial real estate market. Either one could turn this correction into a 20% decline. So, ignore the chicken but watch the canary.
