Stock Market Pricing in a Recession

By: Paul_J_Nolte

Investors are beginning to price into the markets a recession. The non-farm payroll figures out last Friday were worse than the street expected, showing a loss in jobs that for many, solidified a recessionary outlook. Calls for more rate relief from the Fed pushed the expectations for not just a half percent cut in rates later this month, but a strong likelihood of three quarters, if not a full percent cut. While a nice thing to do to get the economy going, the impact of any rate cut this month will not likely be felt until early 2009 due to the lag effect of changes in monetary policy.

The flipside to another rate cut is the persistently weak dollar – and lower rates won't help stabilize the dollar either. If our rates are below those of other countries (and they are) – investors are likely to head to where they can get the highest rates (currently Europe). To top off the Fed's dilemma is still high commodity prices spurred by a robust Chinese economy. While rate cuts are not the solution to a weak dollar and rising inflation rates, the Fed is more concerned with avoiding a recession (too late) than fighting inflation. The coming week provides some information on the lone bright spot in our economy – trade. The lower dollar has boosted our exports while our slowing spending has cut imports. Any bad news here could send stocks lower still.

After taking a flurry of body blows over the past few weeks, the markets remain barely above the lows of late January. If key levels are broken, we could see another 5% hit to prices over the next couple of weeks. Many of our weekly and even daily indicators are approaching bottom points, it will be a rally that will tell whether we are at “the” bottom or merely another resting point before “the” bottom actually is hit at some point in the future.

Outside of bonds and cash, there have been few places of refuge in the markets as even gold and energy issues declined in step with the major averages last week. Unlike past declines, this one is coming on generally lighter volume and lacks the outright fear of past declines. For example, the number of new lows is half of the number in January, total declining volume is well below that of January and the summation index we use – on balance volume has also not set a new low. While many may look at these divergences as positive, they will only become effective if the markets can begin to climb out of the hole (and do it on good volume). Until then, the markets seem to be declining in a careless or haphazard fashion that is too difficult to make sound long-term investments decisions.

The short end of the yield curve is once again below 2% - a level that many thought we wouldn't see for another generation after actually going below 1% in 2003-04. Long rates, along with mortgage rates continue stubbornly higher – with good reason. Long-term bonds are more worried about inflation fears and with commodity prices still rising, it will be hard to bring long rates much lower. Mortgage rates are no longer locked with 10-year bonds, but are now a function of how much a lender is interested in loaning money. Right now, that interest level is low as they are unable to package loans and sell them, hence the reason for the credit crunch we find ourselves. Until the lending doors open – here we will stay with a very low short-term rate and relatively high long-term rates. Good for banks, bad for loans.

By Paul J. Nolte CFA
http://www.hinsdaleassociates.com
mailto:pnolte@hinsdaleassociates.com

Copyright © 2008 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

Disclaimer - The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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