DAVID ROSENBERG
A plain-vanilla correction? More like a rocky road
From Wednesday's Globe and Mail
Published
Last updated
This month’s sharp selloff has raised a lot of questions about whether the latest stock market downturn was just a severe correction that is already beginning to pass or the start of a bear market that will continue to maul portfolios over the year to come.
The answer depends on whether the economy – the U.S. economy, in this case – is still growing or sliding into recession.
When the economy is growing, market corrections typically last only about three months and inflict losses of 10 to 20 per cent before stocks start to head up once again. This was the case in 1966, 1987, 1994, 1998 and 2010. (Although the 1987 plunge was much more intense, it was only so in magnitude, not in duration.)
But a stock market downturn accompanied by a recession is far more serious and far more long lasting. These bear markets tend to last 16 months. Losses can be severe: 57 per cent in 2008-09, 49 per cent in 2001-02 and 48 per cent in 1973-74.
Given the dramatic difference between a plain-vanilla correction and a recessionary bear market, investors are sitting on a knife’s edge. If the most recent downturn was just a plain-vanilla correction, then a buying opportunity is at hand. Indeed, a lot of investors seem to think so, judging by stocks’ rebound over the past couple of weeks. But if the U.S. economy is about to enter a recession, then there will probably be another year of market weakness to endure, as well as the possibility of further losses.
Unfortunately, the signs aren’t encouraging: This patch of market weakness is going on four months old, and has taken stocks off almost 20 per cent from their nearby peak. There have only been three other times in history when the S&P 500 fell as much as it did this time around without a recession following.
If we are headed into recession, a quick turnaround for the stock market is unlikely. History shows that stock prices do not begin to reflect the inevitable ray of light that follows every recession until we are about 70 per cent of the way through an economic downturn.
Alas, that may very well be a story for the fourth quarter of 2012. U.S. real GDP has contracted in four of the past six months, household employment is contracting, and the Economic Cycle Research Institute’s weekly leading economic index just turned negative for the first time this year. GDP forecasts are coming down and it is only a matter of time before earnings do as well.
The fundamental problem is that economic growth never really emerged from the last recession. Creating the illusion of prosperity is different than creating prosperity. In the U.S., U.K. and euro zone – which combined represent nearly 60 per cent of the global economy – a more serious downturn was prevented only by government bailing out the debt-burdened financial and household sectors. Most of the bad debt was simply transferred from one part of the economy to the other.
The burden of excessive debt is still with us today. Government stimulus programs were not properly designed – the multiplier impacts that were supposed to amplify the impact of government spending never kicked in. So we can’t “grow” our way out. Instead, governments around the world are tightening their fiscal belts.
The debt-plagued U.S. economy displays little or no organic strength. Once policy stimulus wears out, the economy sputters – that has been the lesson of the past two years.
The Federal Reserve is important, but its power is limited. Ben Bernanke cannot add empty housing units to the Fed’s balance sheet. He does not have the power to cut tax rates or pass legislation that would make it easier to extract natural gas. He can’t unveil a national jobs training program.
What he is likely to do – and what he reiterated at Jackson Hole last week – is to use what is left in the Fed’s arsenal. The problem is there are no bullets left, not even firecrackers.
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