Tuesday, February 05, 2008

Well That was Ugly

The Dow closed down 370 today after the ISM Non Manufacturing report fell into recession territory. Apparently some hadn't gotten the memo about the economic slowdown. The ISM report showed a similar drop after 9/11 and another similar dip in early 2003. Obviously, this is not good news. I've been through the report and to be honest, I can't find anything positive to say about it.

That does not mean that the stock market did not over react to the report. It is still just one month and does not make a trend. The move in stocks today demonstrates more than anything the nervousness in the market. Anyone lucky or smart enough to buy near the recent lows was itching to take profits. Combine traders with tenuous profits and investors afraid of recession and what you get is a day like today.

This move in the market is a healthy sign. Bottoms are not made in a day or a week. Long term bottoms take time to build; a V bottom would be a sign that the final bottom has not yet been made. I expect to see a lot of volatility over the next couple of months; there will be big up days and big down days. I don't know yet (no one does) whether the recent lows will hold, but I suspect they will. I do not believe this will be a bear market like 2001-2002. The S&P 500 traded over 30 times earnings back then and was nowhere near that high when this started. I suppose anything is possible but a 50% drop from the highs would put us at single digit P/Es, something we haven't seen since the 70s.

Which brings up an interesting point. I've heard a lot of talk about stagflation recently and with gold hitting new highs some are looking to the 70s for clues about the market. So let's do that. I think the period most people are thinking about is the period from 1973 to 1982. The S&P peaked in 1973 and had a nasty bear market similar to the one we had at the beginning of this decade. August 1982 is widely considered the beginning of the great bull market of the 80s and 90s. So here's the chart from January 1973 through August 1982:

And here's a chart of the S&P 500 so far this decade:

The charts are remarkably similar. The bear market at the beginning of each period lasted for approximately 2 years. The recovery to previous highs took about five years. The recovery was followed by another bear market, but not nearly as bad as the one that started the period. Does that mean this market will act exactly like that one? Of course not; no two markets are alike. But if we relate these charts to economic data it may give us some clues about what to expect.

Obviously, the housing market is the part of the economy that has people worried the most so let's look at housing starts:

Maybe this is why the homebuilding stocks are acting pretty good recently. If history is any guide at all we are a lot closer to the bottom than anyone expects.

And since everyone seems worried about the ISM, let's look at the Manufacturing series for which we have a longer history:

This doesn't tell us a lot except that things are a lot less volatile today than they were in the 70s. If recent history is a guide then even if we are headed for recession, the bottom is not far away.

What about employment?

If this is a mid cycle slowdown, like we had in the mid 90s, then this is about as bad as it gets. If this is a recession, we've got a ways to go yet. I'm still betting on a slowdown rather than a full blown recession, but we don't have enough information yet to make a determination.

What about the unemployment rate?

Well, so much for that comparison to the 70s. We aren't even close to the unemployment seen in the late 70s or early 80s. In fact, if the trend of lower highs holds, the unemployment rate is likely to rise only a little further.

One thing that does look a lot like the 70s is the dollar:

One thing that should be obvious from this though is that there is little corellation between the value of the dollar and recessions. We've had recessions when the dollar was rising and recessions when the dollar is falling.

What about inflation? A lot of people, me included, are worried about inflation. Here's the Personal Consumption Price Index:

Seems rather tame when compared to the bad old days, huh? Any inflation is too much for me, but things aren't so bad right now compared to what we've seen in the past.

I could continue in this vein with other statistics, but the evidence is clear. The economy is not great right now, but it is not out of the norm for the last 50 years. In fact, if anything, things are considerably better than at times in the past, particularly the 70s. Are we headed for recession? I don't think so, but even if I'm wrong, we've probably already seen most of the damage. Looking back at the past will not tell us where we are going. It does provide some perspective though and that perspective tells me that all the doom and gloom out there is probably misplaced. Investors need to remember that the goal is to buy low and sell high. The market is giving investors an opportunity to do the buying part of that equation. It just takes a little perspective to gain the confidence to act on it.

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