Weekly Markets Commentary – July 7, 2008

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A Bear Market, But is It a Bottom?

As everyone surely knows by now, the Dow Jones Industrial Average has fallen "officially" into a bear market. From its peak last October, the Dow is down more than 20 percent with the S&P 500 Index very close behind. The question investors are increasingly asking is "have we seen the bottom?"

For the long-term investor this is an easier question to consider. Average bear market declines in the last 50 years have been in the vicinity of the low 20 percents, although the actual range has been quite wide. So even if this one turns out to be worse than average, it is a good bet that a lot of the pain has already been inflicted.

For an investor with the luxury of time and the opportunity to look beyond the valley to the next recovery, then the question of whether a bottom is at hand is less urgent. In fact, with stock prices down 20 percent, putting some cash to work now will likely be seen as a profitable move down the road.

Bottom fishing is a far more compelling question for someone with a shorter investing time horizon, or an investor who is attempting to make tactical portfolio adjustments around a central core. We happen to fall into the latter camp, and for us it does not appear that the bottom is at hand.

Inflation & Recession

We continue to be troubled by the prospect of rising inflation. Enough to expect that the Federal Reserve will eventually be forced to respond with higher interest rates, which will push the economy into recession in the first half of next year. This means that the worst for the economy lies ahead, not behind. Even this forecast would not preclude the market having already reached a bottom, since it acts as a discounting mechanism.

The problem is that the prevailing wisdom on Wall Street does not include a 2009 recession. Many believe that economic weakness will prevent inflation from becoming a bigger problem because it won't provide an opportunity for wage increases to spiral upward.

We believe that higher commodity prices, accommodated by easy money, make higher inflation inevitable.

Recessions generally last for 10 to 12 months. Stocks generally start to recover halfway through. This suggests that we may well reach a bottom in June, but it could be June 2009.

Why We Haven't Hit Bottom

Beyond simply comparing our economic forecast to average historical experience, here are several other, more immediate reasons why we don't think a bottom has been reached:

First, the pressure on consumers continues to build. Crude oil rose again last week, to $146 a barrel. The implications of this extend well beyond the strain on family budgets.

Vehicle sales in June totaled 13.6 million at an annual rate. As recently as December, the run rate was 16.3 million. Ford reported that sales of SUVs declined 55 percent from the same period last year, and sales of its best selling truck model declined 40 percent. And some analysts are speculating that General Motors could be forced into bankruptcy.

Housing prices also continue to fall, and study after study has affirmed the existence and impact that this negative wealth effect exerts on consumer spending.

Unemployment is rising. Almost half a million jobs have now been lost this year. And, while the pace of deterioration may not yet be consistent with a recession, the trend is in the wrong direction.

Stock prices are down. This means that along with housing, the asset side of the individual balance sheet is deteriorating noticeably. Yet debt levels remain high.

Business balance sheets are generally healthier, at least outside of financials. But CEO confidence has eroded sharply, suggesting a less-than-robust pace of business investment.

Economic indicators in Europe have begun to roll over, and spiking inflation in the developing world likely means further efforts to slow the growth rate.

Emerging markets have behaved poorly recently, falling five percent last week alone. The decline on the year is 17.3 percent. Some of this weakness was mirrored in the performance of materials stocks in the S&P 500 last week, as the sector declined almost six percent.

Credit spreads continue to widen. The yield to maturity of the Merrill Lynch High-Yield Master II index rose 15 basis points last week to 11.09 percent. This pushed the spread to the 10-year Treasury note to 781 basis points. In mid-May it stood at 660.

Second Quarter Earnings

Second quarter earnings season gets underway this week against a backdrop of declining estimate revisions and an S&P 500 that pierced its March low last Wednesday, and stayed there on Thursday.

Sentiment has clearly turned negative, but not to levels extreme enough to suggest a buying signal. The VIX (CBOE Volatility Index) has risen from its mid-May low of 16.3, but only to 24.8, well below its previous buy signals in the mid 30's.

We simply have not seen an episode of capitulation selling typically associated with a bottom.

A lot of the weakness in stocks has been attributed to the steady rise in energy prices, and rightly so. This has led some to pin their hopes for a broad rally in stocks on a meaningful correction in the price of oil. Yet, if that hoped for correction comes about as a result of demand destruction, it most assuredly will be accompanied by slower growth around the world.

If, in fact, high energy prices are mostly explained by the fundamentals of supply and demand (rather than any impact of speculation), then it will take a decline in demand to bring about a correction. The likelihood of a meaningful, sustained increase in supply any time soon is slim to none.

So, for many reasons we do not believe the bottom has been established. In the meantime, we continue to underweight equities.

The Week Ahead

The economic calendar is extremely light this week, so earnings will dominate investor focus.

The following week will include reports on both producer and consumer prices. Both are expected to show meaningful increases at the headline level, but a more modest rise in core producer prices, and no increase in core consumer prices.

(Editor's note: The Weekly Markets Commentary will not be published next week. David Joy will be out of the office. The next date of publication will be Monday, July 21.)