Stock Market Parallels

It seems we just closed out 2008 with a "sigh of relief"--only to find ourselves in for a turbulent 1st quarter! January went on record for posting the greatest decline in US stock market history. February ranked 3rd for the greatest decline.

During the course of one brief quarter we experienced both a bear market AND a bull market. What a rarity.

Any time a market moves 20% down from its peak or up 20% off its low, it is labeled a bear or bull market, respectively.

And if you are an investor who was rattled by the severe decline and the rumor of a Dow falling to 6,000 or lower in early March--and cashed in at that time--you missed one of the most historic rises in the stock market in the heart of March.

There are some interesting similarities today with the stock market trends of past, significant economic downturns.

Dshort.com has assembled stock market returns by superimposing the 2007-09 S&P 500 index with the Dow Crash of 1929 and the S&P 500 declines in 1973-74 and 2000-02. The current market decline is measured from December, 2007--the month when the National Bureau of Economic Research (NBER) says this recession began.

Here are some observations:

• The past declines lasted 21 (1973-74) to 34 (1929-32) months. Currently we are in month 17 of this recession.

• In many past recessions (not just the ones viewed here), the stock market has tended to recover some six months prior to the end of the recession.

• The current decline (blue line) reached its early March low point five months ahead of the 1973-74 downturn (red line). This is NOT to imply, however, that the US stock market will not again dip down to that early March point, or lower. Only time will tell.

• During the lowest point of the current decline in early March, we were 16 months ahead of the much slower decline earlier in this decade (green line).

• We are a long, long, long way from the bottom reached during the Great Depression (gray line).
  

Recently I wrote about three recession scenarios: L U V

Depending on which scenario you believe, you may be led to a certain view about when the current stock market swoon will end.

(Click on the following graph for a larger view.)

What's a Depression?

During one of my presentations last year at church, someone asked me for the definition of a depression.

In an informal sense, a recession is two consecutive quarters of negative economic growth, or decline in the Gross Domestic Product (GDP). (For more on GDP see my late January article, That GDP.)

Although there is no formal definition for a depression, most economists agree it is a prolonged slump with a 10% or more decline in real GDP.

With this in mind, here is a graph comparing the decline in real GDP for the current recession with other recessions since 1947. Depression is marked on the graph as -10% at the very bottom.


Even though the current recession is already one of the worst since 1947, it is only about 1/3 of the way to a depression (factoring in a likely bad 1st quarter, 2009).

The next graph compares the current recession, with estimated decline for the 1st quarter of this year, with the more severe recessions of the last century.


Keep this in mind so that you have proper context when you hear the next pessimistic prognostication about a Second Great Depression.

L or U: Counterpoint

I recently published an article with accompanying information about the possibility of a V-shaped recession. This is the more optimistic viewpoint--and it is supported by the consensus view of GDP growth in the second half of 2009. Of course, the consensus could be wrong.

Enter counterpoint: Nouriel Roubini, a professor at New York University's Stern School of Business, says We could end up ... with a 36-month recession, that could be "L-shaped stagnation, or near depression. He puts the chance of a severe U-shaped recession at 66.7 percent, and a less severe L-shaped recession at 33.3 percent.

He has a reputation as the most pessimistic economist in the academic world. He deserves it. His most recent paper is Can the Fed and Policy Makers Avoid a Systemic Financial Meltdown? Most Likely Not.


We are in the 15th month of a recession, says Roubini. Growth is going to be close to zero and unemployment rate well above 10 percent into next year. He sees no hope for the recession ending in 2009 and will more than likely last into 2010.

I believe it is important to consider all sides of this economic debate. It is also important to not get too emotionally invested in outcomes: either by being blindly optimistic about recovery or irrationally pessimistic about depression.

Here is a recent interview worth watching.





By the way, how are Roubini's own funds invested?

They are 100 per cent in equities. In the long run stocks do best and he is not yet close to retirement, so he keeps putting more money into index funds each month, according to an article in the Financial Times by John Authers.

V

President Obama is expressing a more positive view of the US economy. This is constructive, because it is fear which is, in part, hurting our chances for a faster recovery from this recession.

What I don’t think people should do is suddenly stuff money in their mattresses and pull back completely from spending. I don’t think that people should be fearful about our future. I don’t think that people should suddenly mistrust all of our financial institutions because the overwhelming majority of them actually have managed things reasonably well.

During this New York Times interview the president sounded another upbeat note about the economy by suggesting that a surprising number of banks will pass so-called stress tests the Treasury Department is conducting to see if they could weather a prolonged and deepening recession.

When asked how soon he thought the US economy would turn around he said, I don’t think that anybody has that kind of crystal ball. We are going through a wrenching process of de-leveraging in the financial sectors – not just here in the United States, but all around the world – that have profound consequences for Main Street. It is going to take some time to work itself through.

Christina Romer, chair for the Council of Economic Advisors, was more specific in saying, Sometime in the second half of the year...I expect that's when we'll start to see positive GDP growth again and a little after that we'll start to see employment going up rather than going down.


In early February I wrote about three possible recession recovery scenarios: L U V, where a U-shaped recovery is quite pessimistic, V is optimistic and an L viewpoint has been held by many economic commentators.

Recently the Federal Reserve published the following chart. This shows a consensus view that we'll have a decline in GDP this quarter and in the 2nd quarter of 2009, and then there will be growth.

If you look carefully, the shape of this recessionary decline is a V.

If the consensus is correct, we have to tough it out four more months before entering the 3rd quarter. Let's hope they are right!