Dramatic Return of Risk Aversion May Not Be All Bad

Good Evening: In the wake of the mid November washout in almost all forms of risk taking, risk appetites in markets around the world spent most of last week trying to recover. Reaching their short term fill on the day after the Thanksgiving holiday in the U.S., market participants abruptly turned away from the risk buffet today and disgorged more than half of last week’s gains in U.S. equities. Contributory factors included the size of last week’s advance, another batch of horrid economic statistics, tax-loss selling, and, drum roll please…the “official” arrival of an economic recession in the U.S. None of these negatives should be dismissed, but today’s carnage actually generated some hopeful signs.

Perhaps due to the poor travel weather afflicting much of both the East and Midwest, most of the first-string traders and investors returned to their desks this morning in no mood to continue last week’s rally in Wall Street. Global equity markets and U.S. index futures were down prior to the open in New York, and this morning’s batch of economic data was very weak. Construction spending dropped 1.2% (vs. and expected -0.9%), but the bigger negative impact came in the form of an ISM manufacturing survey reading of 36.2, a level not seen since the brutal 1982 recession (see story and Merrill’s take below).

And just as these statistics were causing investors to worry about the length and depth of the downturn evidently under way, NBER finally acknowledged the obvious by proclaiming that the U.S. is now in recession. What shocked economists about the news was NBER’s choice for the starting date — December of 2007! That economic activity has been contracting for a year now must be a tough pill to swallow for the practitioners of the dismal science, since, up until a few months ago, the majority of economists were claiming to foresee no recession on the horizon in the U.S. According to NBER, they should have been looking for the downturn in their collective rear view mirrors.

Reactions to the aforementioned news items were swift and they affected every market. Stocks fell, Treasurys jumped, “carry currencies” soared, and commodities sank. The theme of risk aversion was omnipresent even before the opening bell rang at the NYSE. The major averages opened 2% to 3% lower and never looked back. Not once did stocks even come close to challenging the unchanged mark. After drifting sideways with a downward bias during the middle part of the session, equities simply fell apart during the final hour of trading. By virtue of losing “only” 7.7%, the Dow was today’s relative winner. The S&P, Dow Transports, and NASDAQ were all tagged for losses approaching 9%, but the poor Russell 2000 was mugged to the tune of almost 12%. Treasury yields fell broadly after Chairman Bernanke all but promised a round of Quantitative Easing that could involve the purchase of longer dated Treasurys. Yields declined between 8 and 22 bps as the curve noticeably flattened. The dollar rose 0.5%, but the carry currencies (yen and Swissie) rallied even more during today’s flight away from risk. Commodities were caught up in it, too, as crude oil slipped back below $50/bbl. and precious metals were thumped. The CRB index declined 3.5%. It’s hard to call today’s action anything other than a meltdown in miniature.

As mentioned at the outset of this commentary, I saw some hopeful signs for equity prices in today’s brutal price action (i.e. only 2 of the 500 stocks in the S&P finished in the green). How does a violent, one day drop qualify for such optimism? Couldn’t tomorrow be just as bad, and won’t tax-loss selling keep the stock market on its heels through year end? Sure, and some of the major averages might even set a marginal new low in the process, but I believe that the odds favor that the November lows will hold (for now). Consider the following:

1. Five straight up days through Friday displayed persistence and means demand for equities can be found (at a price).
2. Rather than touted, last week’s rally was doubted on T.V. and in the press
3. Today’s swift and sharp drop resembles more a counter-trend move than a trend move (remember the violent and brief rallies during Sep/Oct/Nov?)
4. The official announcement of a recession could represent one of the last psychological shoes to drop. Once recessions become “official”, many investors take it as a sign to start accumulating risk positions ahead of an economic upturn in the months ahead
5. The Fed seems to be embarking on a significant policy shift toward Quantitative Easing. Such a shift might lead to more risk taking by leaving little value in “safe” choices like cash and Treasurys. If the Fed can force term premiums down, risk premiums should eventually follow, which will help further thaw the credit markets.
6. T-Bonds are starting to act like a bubble in mid blow, at least according to Merrill Lynch (see below)
7. A large stimulus package is likely early next year
8. Governments and central banks around the world are starting to take similar monetary and fiscal actions.

Do these positives add up to a new bull market, and have I abandoned my traditional skepticism in favor of hoping happy days are here again? The short answer is “no”, but a better answer makes an important distinction between what “I” think will happen and what I believe “others” might think will happen. For months it seemed everyone was obsessed with picking a bottom. Now that a tradable, intermediate term bottom may be at hand, all rallies are suddenly suspect and there are 498 reasons to doubt the S&P 500. Count me as long term skeptical, since even if the latest round of policy “fixes” work they will create their own problems down the road. Let me also say I’m under no illusion that our government is bigger than our economy and that our economy will likely continue to deteriorate in the months ahead. For the next few weeks or even a couple of months, however, mark me down as one who thinks the bears have at least as much risk as do the bulls.

— Jack McHugh


U.S. Stocks Drop, Ending 5-Day Rally; GE, JPMorgan Shares Fall

Recession in U.S. Started in December 2007, NBER Says

ISM Factory Index in U.S. Decreased to 26-Year Low

U.S. Treasury Yields Drop to Record Lows on Recession Concern

Fed Shifted Policy to Quantitative Easing, Ex-BOJ Deputy Says

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ISM hits 1982 low prices colla.pdf

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North America Morning Market M.pdf

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