Friday, September 25, 2009

We’re in a recession… so why hasn’t the stock market listened?

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

It’s no secret that the U.S. and most of the world has been in a recession since late 2007, although so many people have felt the pain long before it “officially” began. The National Bureau of Economic Research (NBER), a non profit group from Cambridge MA, is the official scorekeeper of recessions and expansions and use various objective and subjective methods to declare the start and finish.

Most analysts keep it simple and use two consecutive quarters of negative gross domestic product (GDP) growth as the line in the sand for recession. The problem here has been that by the time a recession has been triggered, it’s usually close to being over. That was until the tsunami of 2008, which will go down as one of longest economic downturns in history!

So enough with the textbook info, most people want to know why the stock market has rallied so hard in the face of horrific employment numbers and an economy that keeps shrinking. I can give you the easy one line answer and then offer some details.

The simplest reason is that the stock market is one of the greatest discounting mechanisms in the entire financial system. By discounting, I am not talking about something in a retail store that’s offered at 20% off. Rather, the behavior of the stock market today is signaling economic activity three to nine months down the road. In this case, although the reports remained dire in March and April, the stock market rallied because it was snuffing out that things were about to become a lot less worse than they have been. And that would eventually lead to some kind of recovery.

Let me give you some more examples.

In October 2007, the market made its all-time high above 14,000 and then promptly collapsed 16.50% to 11,700 by mid January 2008. During that three month stretch, corporate earnings and economic numbers continued to show good growth, coming in as or better than expected. A significant rally began again in March 2008, following the Bear Stearns rescue and the economic effects of that rally showed up in the June/July period.

Following Lehman’s vaporization in September 2008, the stock market fell off the cliff, losing more than 20% in one week, yet the economic numbers did not severely worsen for three to four months.

My all time favorite example of why you should watch the stock market’s behavior over what news is actually being reported takes us all the way back to 1990 when Iraq invaded Kuwait.

The economy was already showing very early signs of weakening with inflation ticking up and the S&L Crisis becoming front and center. Saddam Hussein was the catalyst that actually pushed it over the edge. Oil spiked to over $40, which at that time was viewed as deeply recessionary. Another $20, it was thought, would throw us into another depression! I guess those analysts wouldn’t still be employed today with that mentality.

Anyway, stocks sold off very hard, losing more than 20%, from July to October 1990, while the economic reports just began to weaken. From that historic bottom in October 1990 with the recession deepening, banks going out of business on a weekly basis and the U.S. about to begin its first war since Vietnam, the stock market took off like a rocket ship, soaring more than 30% by the time the recession was officially declared over in April 1991.

The stock market almost always looks ahead at economic activity three to nine months down the road. If you are basing your investing decisions on the economic or earnings news of the day, you will usually find yourself chasing your tail. Remember, what’s being reported today is already in our rear view mirror. It’s where we’ve been. Imagine driving your car to the supermarket and only looking in that rear view mirror. Not a pretty outcome, right?

The stock market hammered out that historic bottom this past March, not because the landscape was getting better at that time, but because it saw a light at the end of the tunnel three to nine months down the road. Stocks typically begin to rally around the time where the recession is at its worst and the fewest people expect it. It does its best to confound the masses, so as investors, we should always expect the unexpected and look ahead.

If your philosophy has been to wait until the economic reports signal a recession or expansion, you may be making investment decisions at precisely the wrong time. The reasons for the beginning of a bull or bear market are irrelevant. If you must have rational explanations for things, the stock market is a tough place to make money unless you have the unique ability to invest with hindsight.

To quote John Maynard Keyes, “The stock market can stay irrational longer than you can stay solvent”.

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