Stocks Always Recover Before the Economy Right? Don't Be So Sure

By Jim Welsh | October 22, 2008 | 3:24 PM | 0 Comments

Although most analysts believe the stock market always bottoms before the economy recovers, (since the stock market is a discounting mechanism), that's not what happened in 2001. The NABE determined in early 2002, the recession that began in March 2001, ended in November 2001. But the stock market didn't bottom until October 2002, and was up less than 3% from that low in March 2003. Does this mean the stock market was discounting the past?

Discrepancies like this don't seem to matter to those who just want to believe the market knows something about the future. At some point the stock market will bottom, and the economy will begin to recover. With the benefit of hindsight, (sometime in 2009 or 2010), the believers will point and say "See the stock market anticipated the recovery!" What they won't tell you is that a good number of people thought the market bottomed in August 2007 with the S&P at 1370. Even more were sure that the failure of Bear Stearns surely marked the bottom in March, when the S&P was 1257. And, when the S&P held 1200 in mid-July, and the government took over Fannie Mae and Freddie Mac, the ‘bottom is in' bandwagon was full. If I told you I was psychic and could guess a number between 1 and 100 randomly chosen, by someone I did not know, and then showed you a tape of someone's absolute amazement, when I guessed their number correctly, you might be just a little impressed. Of course, what I didn't show you was the tape of the other 34 guesses, with other individuals that were wrong!

In late July I was included in an article in the San Diego Union entitled "Five Experts' Advice for Tough Times." I was included in part, I think, because I have shown Dean Calbreath (author of the article) the tape of my number guessing ability. In that article, I stated we were in a bear market, and thought the DJIA would decline to 8,000. (The DJIA was 11,500 at the time). On October 10, the DJIA fell to 7,882. So, has the bottom in the stock market been reached? It's certainly possible, but there are fundamental and technical reasons why the market will likely go lower. If the economy performs as poorly as I expect, corporate earnings will be crummy for longer than investors expect.

Technically, the market got more oversold in October 2008, than it was in July 2002. The July 2002 low was followed by a slightly lower low in October 2002, and a second retest in March 2003. Since the October 2008 low was more oversold than the July 2002 low, it seems more likely this low will be followed by additional selling waves, especially since the economic fundamentals are worse than in 2002. The low in October 2002 was 7,197 on the DJIA. My guess is that the DJIA will drop below 7,882, but hold above 7,200 in coming weeks. If this develops, a one to three month rally could follow, as analysts convince themselves that a narrowing in credit spreads and a second bigger stimulus plan will mean the economy will begin to recover by mid 2009. As more investors embrace this scenario, selling pressure will dry up, and coupled with a little buying and some short covering, the market will rally on lighter volume. This is what happened after the March low, and the market rallied for two months. If this plays out, the DJIA could rise to 9,600-10,200, and the S&P to 1000-1050. My guess is that after this rally is over, the DJIA will likely drop below 7,200 by next spring.

If the DJIA does drop below 7,882, traders should look for an entry, especially if the DJIA climbs above 8,200. Use DJIA 7200 as a stop. My managed accounts, for the most part, have been 100% out of the market since July, in Treasury Bills since mid September, and sleeping at night.