Drop a dead cat off a high enough building and it will bounce upon impact. We on Wall Street call that “a dead cat bounce” which explains last week’s rally. Those who thought the gains in the S&P, NASDAQ and Dow signaled the end of the correction are hurting right now. A week’s worth of gains fueled by yet another anticipated Fed cut was given back this week. Tuesday alone saw over a 3.5% decline in the averages. Since then we’ve witnessed steadily declining world stock markets.
Don’t be too hard on yourself if you were suckered into chasing stocks. Over the last few years most of us have been rewarded by “buying the dips” but this time there is a difference. We are heading into recession and stock markets react differently when the economy is slowing. In my last column I explained that we may have reached a bottom but the market would need to retest the lows more than once over the course of the next several weeks. That process is on-going. I expect two things could happen.
One, stocks will continue the bottoming process: rebound off the low, rally again and then retest that low. The second and more unsettling case would be the markets continue to go lower. I put that probability at 50-50. Here’s why.
Historically, the S&P 500 index corrects an average of 26% heading into a recession. Right now we are down about 15% from the October, 2007 highs so we would need to pull back an additional 160 points or so from here or another 10-11%.
The bear case is certainly convincing. In addition to all the bad news we know: sub prime lending, residential real estate, slowing consumer spending and confidence, higher inflation etc., there are additional storm clouds on the horizon. Commercial real estate is starting to falter, consumer credit card and home equity loan delinquencies are rising nationwide and there is still no bail out solution for the bank insurance companies.
The bulls argue that we should see some light at the end of the tunnel by summer or at least September. That’s when the impact of the first rate cuts by the Federal Reserve will start to be felt in the economy along with the newly- passed economic stimulus package. Stocks, they contend, are cheap and present a buying opportunity for those patient enough to ride through this volatility.
Right now I would recommend a wait and see attitude until the markets retest the lows of two weeks ago. Given the circumstances, I believe that is the prudent approach.