As we slide into the bear market don’t be fooled into thinking that a new bull market is starting with every rally. The U.S. is either in recession now or will be entering one soon, and the chances are that it will be much more severe than the last two in 1990-91 and 2001. The problem that started with the biggest housing decline in the post-war period is spreading throughout the economy. Consumer spending is slowing down sharply as a result of falling housing prices, lower real wages, a weakening labor market, a lack of savings, enormous debt burdens and high energy prices. Capital expenditures generally follow consumer spending down by a quarter or two, and declining core durable goods orders indicate that this is about to happen in the period ahead.
In addition the credit turmoil seems far from over, and the problem goes far beyond the subprime sector. The fragility of the mortgage insurers threatens the triple-A rating of about $1.2 trillion in municipal bonds. Today the New York State Insurance Department said a workout would take more time, casting doubt on whether a government sponsored workout would ever happen. In any event, the world is burdened by excessive debt and leverage throughout a large part of the financial system, and the working off of the debt and deleveraging of the system is a highly complex matter that will not only take time, but will result in significant restriction of new credit while this is happening. The process is also likely to result in even more massive writeoffs with a further downward drag on the real economy.
The panic in Washington on the part of the Fed, the Administration and Congress indicates how seriously they view the economic and financial situation. Any problem that brings George Bush and Nancy Pelosi into agreement so quickly must be viewed as exceedingly serious. However, any fiscal policy aimed at preventing recessions is usually too little and always to late. This is amply illustrated by the following table from the New York Times, indicating that by the time a bill has passed the recession has already started. The IRS is already saying that even if a fiscal relief bill is passed soon, they cannot get the first checks in the mail before late May and will take ten weeks beyond that to complete.
Similarly, the Fed’s sudden reduction of the funds rate by 75 basis points only a week before a scheduled meeting indicates that they, too, are behind the curve. Even in normal times Fed rate cuts have invariably been late since it takes anywhere from 6-to-18 months to boost the real economy. In the post-war period the U.S. has endured ten recessions despite Fed efforts to avert them. Now with financial instruments far more complex than in the past, the Fed has even less control over the economy. As recently stated by former Fed Chairman Paul Volcker, "Too many bubbles have been going on for too long. The Fed is not really in control of the situation."
In our view the market has entered a major bear trend that has a long way to go. There is no way to discount the impact of future writeoffs, the resolution of the credit crisis or the length and depth of the recession. Furthermore, earnings estimates have only started to come down, and there are a lot more downward revisions in store. In the last two weeks alone Standard & Poor’s’ estimate of S&P 500 reported earnings for 2007 has dropped 3.8%, due entirely to a downward revision of the 4th quarter by 19%. However, they are still estimating a 2008 earnings increase of 12.9%, an estimate that is too high even for a slowdown, let alone an outright recession. We think it’s more likely that 2008 earnings will decline from 2007, and not show any increase at all.
The last eight recessions have been associated with S&P 500 declines averaging 30%. If this turns out to be a typical recession (and it could easily be worse), the index would drop to about 1100, a decline of about 19% from today’s close of 1352. This would be about 15 times our 2008 trendline earnings number of $72, about the same P/E ratio as the bottom in 2002. However, the last eight market bottoms featured an average P/E ratio of 11 times trendline earnings. If that happens this time, the S&P 500 would end up at about 800, an approximate 40% drop from here. Whatever the final trough turns out to be, it is enough to say that there is a great deal of risk still in the market at current levels. In the meantime, don’t be fooled by typical bear market rallies that are often mistaken for new bull markets. According to Investors’ Business Daily, "the nine biggest up days in Wall Street history all occurred during the bear market of 2000-02."
