W, NOT V
The V-shaped recovery lasted two quarters — it’s now starting to look like a W. After swinging wildly on the back of the massive fiscal and monetary stimulus from -29.87% on December 5, 2008, to +28.54% on October 9, 2009, the ECRI leading economic index (smoothed) has slumped all the way back down to 9.0% in the May 14 week (down from 12.15% the week before in what was the steepest one-week slide on record). At 9.0%, it is back to where it was last July when the S&P 500 was hovering near the 900 mark. In the past 30 years, there has only been one other time when the index fell this far over such a time span and it was during the depths of despair in early 2009.
The downdraft in the market in recent weeks reflects the financial risk related to the European debt crisis, the monetary tightening in China and the re-regulation of the financial sector that is currently making its way through to Congress. The next leg down in the equity market specifically and cyclical assets more generally is economic risk. Equities went into this period of turbulence priced for peak earnings in 2011 and with a tailwind of positive earnings revision and positive guidance ratios from the corporate sector. If the ECRI and the Conference Board’s own index of leading economic indicators, which dipped 0.1% in April, are prescient, then they are portending a period of sub-par economic growth ahead (the ECRI is pointing to 1½% real GDP growth in the second half of this year). As the events of 2002 showed, more-than-fully valued markets do not need a double- dip scenario to falter — a growth relapse can easily do the trick. It’s still time to be defensive and too early in this correction to be picking the bottom.
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