Uh Oh! Equity Slide Poses New Risk to World Recovery

June 22, 2009

The world economy performed better in the second quarter of 2009 than in either of the prior two quarters, inspiring hope that a recovery will begin to emerge in the second half of this year.  Some analysts in fact are claiming that the U.S. business cycle hit bottom last month.  Other regions like Europe will swing into an expansionary phase somewhat later, but the second derivative of economic activity is seen to be improving pretty much everywhere.

This confidence had several elements.  The recession is long in the tooth.  The longer it goes, the closer it is to an end.  Rewards from the substantial macroeconomic and microeconomic aid that has been provided have emerged, but much of their support remains in the pipeline and will be felt later.  Hard data trends for demand and output are looking better.  Financial markets are performing better too.  Interest risk premiums have diminished, for example.  And equities had pared their losses.

The lowest closes in this recession for many stock markets were recorded on March 9th.  At that time, the DOW, Nasdaq, and S&P 500 indices showed losses from today’s 52-week range highs of 44.7%, 48.3%, and 49.5%.  The Nikkei and Dax had plunged 48.9% and 44.2%.  In combination with plummeting real estate, there was a monster negative wealth effect afoot in the U.S. and world economies.  But in the three months from March 9 to June 12, the three U.S. indices advanced by 34.4%, 46.5% and 39.7%, while the Nikkei and Dax rebounded 43.0% and 37.3%.  With a sigh of relief, investors stopped fearing that the worst imaginable scenario was also the most likely one.  They had smelled a far direr outlook in March than June.  Accordingly, a crucial element of the optimism of early June had an expectation component that was uncorroborated in current conditions.  The German IFO Institute business climate figures released today illustrated this point.  Its overall index improved 1.6 points to 85.9, twice as much as analysts were forecasting, but current conditions actually dipped by a tenth of a point to a new low.  The entire increase from May was concentrated in expectations about the coming six months.  If global equities revisit their lows, market psychology will feel much as it did last March, and the onset of recovery will slip further into the future.

Over the last six trading sessions, the DOW, Nasdaq, S&P 500, Nikkei, and Dax dropped by 5.2%, 5.0%, 5.6%, 3.1%, and 7.4%.  Those losses seem small compared to the aforementioned gains from March 9 to June 12.  However, they accrued in a much more compressed period of time, just over a week compared to a whole quarter.  With that fact in mind, the reversal of March 9 – June 12 paper gains is not at all trivial.  20.4% of the DOW’s recovery has vanished.  19.7% of the S&P’s rise is gone, too, and those erasures are eclipsed by the DAX, which has rewound 27.3% of its advance.  In the United States, consumers are smarting from greatly reduced wealth.  The spring stock market recovery stopped the bleeding  but maybe only temporarily.  Market net drops from their 52-week highs have risen back to 30% and exposed a possibly serious drawback in the guarded optimism that had been returning.  Analysts didn’t factor in the caveat of “what if equities slide back to their lows?”

Stock values were getting ahead of themselves, so a significant correction was more than a remote possibility.

Copyright Larry Greenberg 2009.  All rights reserved.  No secondary distribution without express permission.


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