US market has further to fall

Serious Money: New year cheer has been noticeably absent on Wall Street so far in January as economic data has shaken investors' convictions that a recession can be avoided in 2008.

The US stock market peaked last October and has since dropped by more than 10 per cent, registering its first year-on-year decline since the summer of 2003. The downward trend in stock prices has become ever more pronounced as the so-called mid-cycle pause in economic growth that Wall Street peddled last summer has since degenerated into concerns over a full-blown recession.

The blue-sky optimists have since divided into two camps - those who believe that the economic expansion will continue and those who insist that an impending recession is already reflected in stock prices. Both camps are almost sure to be proved wrong.

Investment managers who argue that a recession can be avoided in the year ahead are fighting an increasingly untenable position as the economic data released since the start of the year, particularly the employment report for December, reveals that the American economy is either on the precipice or already in recession.

Indeed, both the slowdown in year-on-year growth in total payroll employment to below 1 per cent and the more than half-percentage point surge in the unemployment rate are consistent with an economy that has begun a business downturn.

Those who argue that an economic downturn is already reflected in stock prices are not supported by historical fact. The thesis is based on the theoretically sound principle that stock prices are a leading indicator of future economic activity.

It is also true that an impending economic downturn has become increasingly reflected in stock prices as price weakness has spread from consumer discretionary names such as Ford, General Motors and Home Depot, and financials including Bear Stearns, Citigroup and JP Morgan, to other areas of the market, notably the technology sector.

The argument is increasingly compelling when one considers that, while the S&P 500 is down roughly 12 per cent from its all-time high, the decline on a price-weighted basis is far more severe.

Stock prices do track the economic cycle closely, which is intuitive since the business cycle is the primary determinant of corporate earnings. Stock markets typically anticipate the peak in economic activity well in advance, beginning a cyclical decline some seven to eight months on average before the downturn arrives. Prices typically register a double-digit decline before the economy sinks into recession.

If the US economy did indeed enter a downturn in December, then stock prices have followed the historical pattern quite closely with losses from October's market peak exceeding 10 per cent in November's final week.

The acceleration in the stock market's decline on Tuesday following disappointing retail sales numbers and larger than expected losses at Citigroup has caused some to suggest that a bottom may be within reach. Unfortunately, it would be unusual for a market low to occur so soon after a recession begins. Historically, two-thirds of the cumulative decline in stock prices over a cyclical bear market is incurred after the economic peak and prices drift lower for a further six months on average bringing the cumulative loss to more than 25 per cent. This suggests that the current market setback has further to run.

A bear market typically proceeds through three distinct psychological phases. Investors dismiss the initial downdraft in stock prices during the first phase arguing that the economic expansion remains on track. Most investors remain bullish and perceive the drop as a buying opportunity.

However, the subsequent rally fails and stock prices are carried to lower lows during the second phase as some portfolio managers lose their nerve and reduce exposure. Unfortunately, a large number of investors hang tough arguing that the worst of the decline has passed and that a bottom is near.

Once again the subsequent rally fails and the market hits new lows during the bear's final phase as misguided bulls throw in the towel. The market is then poised to register its ultimate low.

The current downdraft in stock prices entered its second phase on Tuesday as market indices plunged to lower lows.

This is unlikely to represent a buying opportunity and any subsequent bounce should fail as most investors continue to debate the likelihood of recession and should instead be focusing on how protracted and severe it will be. There is still time to reduce exposure.

www.sequoia.ie