Morning Cup of Jo: What If The Recession Storm Hits?
Whether or not it's just all the talking heads and financial papers trying to make news, the "R" word has been passed around like salt at the dinner table.
- With all that has transpired (technically and fundamentally) in both the equity and debt markets since mid-July we have to consider whether or not the economy will fall into recession and the potential drop of the markets.
- I analyzed the duration and magnitude of past recessionary periods and related them to the action in the market. Applying that analysis suggests a potential drop in the S&P 500 Index down to 1,150 (-26%) by June of 2008 (11 months). Basically, another 9 month stint of downward volatility to the tune of another 20%, give or take.
- If the SPX busts the horizontal neckline of around 1,360 with a light volume re-test, this would imply the end of the cyclical bull market and a measured move lower of about 195 points, which corresponds to a massive floors & ceilings support around 1,165. This is exactly (give or take a percent) where an average recessionary decline would put the market.
Market Commentary: What If?
As you roll out of bed in the morning, shuffle to the coffee maker and find your way to the shower you glance out the window and notice it's unusually dark. Just then you notice black clouds, see a glimpse of lightening and hear the rumbling of thunder in the distance. The preparation for the remainder of the day begins with possibilities and judgments of what may transpire. Immediately your thoughts shift to wearing your "not-so" expensive shoes, least favorite suit and where you left that damn umbrella. This is not to say it's definitely going to rain, nor how bad it will be if it actually does. Even so, like having arrows in a quiver, you want to be prepared.
With all that has transpired (technically and fundamentally) in both the equity and debt markets since mid-July we have to consider, gauge and calculate "What if?" Whether or not it's just all the talking heads and financial papers trying to make news, the "R" word has been passed around like salt at the dinner table. So again I ask, "What if?" Today's 'Jo' will attempt to answer just that question.
Since the late 1940s there have been ten recessionary periods, on average one every six years. Recall that a recession is characterized by a decline in real GDP for two or more successive quarters. I have compiled some interesting data about said periods and would like to relate it to today's market environment.
The first two tables show the periods of recession and correlated equity market downturns for the U.S. economy. As you can see, the length of time of the recessions – defined as the peak-to-trough months of actual GDP – is 10.3 months*. As for the equity markets (represented by the DJIA – Dow Jones Industrial Average), the average length of declines during such periods is just over one month longer (11.5 months), again measuring from peak to trough. This only makes sense and should be of no surprise that the length of time of an economic downturn and market decline is roughly comparable.
US Periods of Recession*
*Data from U.S. Census Bureau Poverty Tables
US Equity Markets
However, the last column of the equity market table above (percentage market decline for recessionary periods) and the following table created various points of interest and present some relevance when evaluating today.
The first attention-grabbing observation was the average percentage market decline. Of the last ten recessions the average downturn was 26%; in essence this represents the traditional definition of a bear market. The second key point comes from the table on the right - the average number of months the equity market peaked prior to GDP.
In all but one instance -- the 1980 recession -- the equity market topped, on average, four months prior to real GDP topping. Interestingly enough (although not relevant for today's topic) the equity market's bottom also preceded the GDP bottom by an average of three months. And who said the equity market is not a predictor of the economy? Nonetheless, given this history lesson of past recessions provides some data points to work with.
So for the sake of argument let's assume the talking heads are correct and we are heading for a recession. If I also assume the mid-July peak at 1,555 in the U.S. equity markets was the top, I am able to do some calculations. Applying the aforementioned numbers from the recessionary tables suggests a potential drop in the S&P 500 Index down to 1,150 (-26%) by June of 2008 (11 months). Basically, another nine-month stint of downward volatility to the tune of 20%, give or take.
Evaluating the data as a technician, I thought it apropos to apply some trend analysis. Below is a weekly chart of the SPX I have posted multiple times in my commentary. I again have outlined the Cyclical Bull Market Trend (BLACK) which began back in 2003. Also outlined is the Secondary Bull Market Trend (BLUE) which was broken back in late July. In mid-August, yet briefly, the market re-tested a horizontal support (around 1360) dating back to November of last year and March of 2007. As recently as last week the market re-tested the corresponding horizontal and upward sloping resistance around 1,500.
From a technical standpoint the SPX is beginning to form an extremely important topping pattern. However, let me emphasize the word "beginning." In the coming weeks and/or months if the SPX busts the horizontal neckline of around 1,360 it may have enormous repercussions. This would imply two things. First, if the market broke the approximate 1,360 level and confirmed with a light volume re-test, this would imply the end of the cyclical bull market. Second, from a standard technical point of view, the ensuing drop of a neckline break is traditionally equal distance from the peak of the pattern to the neckline. In this case it is about 195 points. By subtracting the same 195 point from the neckline it corresponds to a massive Floors & Ceilings support (RED) around 1,165. Coincidence or not, this is exactly (give or take a percent) where an average recessionary decline of 26% would put the market.
Click to enlarge
"What if?" is a question everyone has to ask to be able to properly prepare for any outcome. Some over-prepare, some under-prepare and some, believe it or not, don't at all. My objective today is to give you a glimpse of the past in hopes to assist you in understanding the future. There are a multitude of factors which have to transpire before the "R" word becomes a reality. However, the skies have turned dark and that possibility is looming. At a minimum one should consider a different pair of shoes.
As I have stated in past articles, if the dominoes that have already fallen cause the consumer domino to topple, then the likelihood of today's analysis unfolding becomes much more probable. Disturbingly enough, this could take some time to materialize. The good news is that more than likely the equity and debt markets will lead the way and in the process provide clues about the health of the consumer, and therefore the economy.
Stay tuned and good luck!
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