Last week, we had cautiously remarked that when the holiday hiatus comes to an end, traders are likely to take stock of events that have unfolded over the past few weeks and possibly dictate the short term course of the front line indexes. 2007 ended on a bad note with all the front line indexes closing in the red; 2008 has begun on an even worse cue with all the indexes declining sharply this week amidst some very dire economic data. Ominously, S&P is down 3.86% in the first three trading days of the year, its second worst start ever.
The Nasdaq Composite has lost 5.5% in the same period, its worst start ever. Intel suffered two downgrades this week on concerns that the strong growth in the PC market in 2007 will begin to temper this year and the high inventory levels that could extend through the first half of 2008, pushing the stock to its largest weekly decline in two years. Friday's remarkably sharp decline, although partly fueled by the dismal jobs data outlined below, was the largest one-day decline for the Nasdaq in almost a year.
Traders seem to be in a hurry to book their profits after seemingly holding themselves back for most of December – a move possibly aimed at postponing their capital gains until 2009. Not to be left behind, analysts seem to be entering 2008 on a bearish note as well. Back from their holidays, analysts have downgraded stocks all across the spectrum, to the extent that as on Friday, none of the S&P sectors had a positive number of net revisions.
The unrelenting selling pressure is taking its toll. We have explained previously how the small and midcap sub-universe would likely bear most of the brunt of a sustained credit crunch. That contention has come true with the small and midcap benchmarks witnessing milder recoveries and more severe declines. The Russell 2000 is now well below the August summer trough at a 15 month low.
The S&P 500, the commonly used benchmark for stocks in the United States, gave a 3.5% return in 2007 (before adjusting for dividends), less than the latest headline inflation number and less than the return given by a typical money market fund. However, a lousy stock market in 2007 may just look good compared to the predictions of an awful one in 2008. The weakening economy is now threatening to snowball into a full-blown recession sometime this year. Indeed, some like the revered Bill Gross of PIMCO believe that December may have actually marked the beginning of a recession. Why is this important? Every recession in post-war history has been associated with a stock market decline. The average peak-to-trough decline in stocks (distinct from the economic peak-to-trough that lags the one in asset prices) in a recession is a whopping 28% - an unequivocal proof that recessions and hard landings are associated with sharp, severe and sustained bear markets. As an aside, stocks are now beginning to look a bit cheap. Bear Stearns is now trading under book value, the first investment bank to do so in almost a decade. But as any old-timer would vouch, the bottom of a bear market can be quite elusive.
Recessions are also associated with sharp drops in earnings, of the order of 15-20%. The possibility of an earnings recession highlighted in this space earlier also seems to be coming true. Reuters' estimates for 4Q'07 S&P 500 earnings have swung wildly from a 11.5% growth at the start of 4Q to a 6.5% drop this week – the biggest quarterly move since Reuters began compiling analysts' forecasts in 1999.
For those not familiar with Chinese astrology, 2008 is the 'Year of the Rat', the first sign of the Chinese zodiac, a year of plentiful opportunities and prospects and relatively free of turbulence.
