Double Dip Debate Escalates

Good Evening: U.S. stocks fell for a second straight day today, as early rallies on both Monday and Tuesday gave way to selling in the afternoon. The primary catalyst for today’s downbeat session (volumes were light and breadth was poor) was yet more confirmation that housing seems to be suffering a post-bubble relapse, but ordinary profit taking may have also played a role. From the 1042 low on June 8 to yesterday’s 1031 high, the S&P 500, the S&P 500 had risen almost 9% in just 9 trading days. Some sort of set back is understandable in light of these gains, but the selling grew a little more urgent when the twin supports of 1100 and the 200 day moving average gave way this afternoon. Whether stocks will either regain their footing or continue to slip is an open question, and part of the answer may have to do with the perceived health of the world’s largest economy. The debate over whether the U.S. will suffer a “double dip” recession has escalated in recent weeks, so perhaps we should investigate what the fuss is about.

Equity prices began this week with an upside bang when China announced it was finally abandoning the yuan’s peg to the U.S. dollar that had been in effect since the dark days of late 2008. Bourses around the world rejoiced at the news on Monday, but the major averages in the U.S. couldn’t hold their early gains. Perhaps the disappointing reaction in this country can be traced to a notable lack of transparency surrounding this policy change by Beijing, and sellers jostled with one another all afternoon until the indexes finished in the red on Monday.

Stocks overseas were down in sympathy overnight after yesterday’s disappointing finish on Wall Street, but U.S. stock index futures were actually higher going into Tuesday’s open. After rising approximately 0.5% in the early going, however, prices pulled back to the unchanged mark when the latest housing stats came out. Existing home sales fell 2.2% in May versus expectations for a significant gain. The averages then spent the next few hours hovering just over and under yesterday’s closing levels, and not even a Louisiana judge’s injunction to lift the Obama administration’s moratorium on offshore drilling could ignite much buying interest. Small cap stocks, the Dow Transports, and the homebuilders all got weaker as the day progressed.

With two hours left in the trading session, the S&P 500 took out yesterday’s lows and began to follow the aformentioned groups lower. There was no big whoosh to the downside, but market participants didn’t seem happy that the S&P didn’t put up much of a fight before both the 1100 level and the 200 day moving average were taken out. By day’s end, the NASDAQ’s -1.2% loss was the smallest among the major averages, while the Russell 2000 (-2.15%) and the Dow Transports (-3.85%) were the leaders to the downside. Treasurys were the biggest beneficiary of the weakness in equities, and yields on U.S. government paper fell between 3 and 9 basis points across the coupon curve. Perhaps anxious over tomorrow’s World Cup soccer match against Algeria, team U.S. dollar could only muster a fractional gain today. Commodities had no such allegiances to fret and simply followed stocks to the downside. Led by weaker energy prices, the CRB index lost 0.4% on Tuesday.

Risk became a four letter word during the financial crisis, but from March of 2009 until April of this year, investors rediscovered risk taking. The ardor for risk taking substantially cooled from late April through early June, but risk taking was just starting to come back this month when it started to shrivel again this week. Underlying this proclivity among investors to shift from “risk on” mode to one of “risk off” is a concern about the sustainability of the economic recoveries around the world. With brightening prospects for growth in Asia largely offset by the increasingly feeble looking prospects for Europe, the fulcrum of global economic activity is currently centered in the United States. Most economists are of the opinion that the recovery in the U.S. has become self-sustaining, but a growing band is calling for a “double dip” recession.

The final two articles you will find below try to contribute to this debate, mostly on the side of the self-sustainers. The first is a piece by the economists at Bank of America/Merrill Lynch. They attempt to answer those who have pointed to the recent flagging in the index of leading indicators by Economic Cycle Research Institute (ECRI) as a concrete reason to fear another recession in the U.S. Not so, say the BAC/MER team; there is no “holy grail” of economic indicators, not even the vaunted predictive qualities of the good folks at the ECRI. Their point that “each cycle is different” and that good judgement cannot be replaced by any model makes the piece worth reading.

The London-based fixed income team at Credit Suisse also thinks the economic recovery under way will muddle through to middle age, and they offer myriad reasons why in their latest “Market Focus”. This CS team has been among the more optimistic group of forecasters since the turn last year, and they remain so in this latest offering. The thrust of their piece is that history is not on the side of the double-dippers, that failing to reach economic escape velocity is fairly rare. Interestingly, however, they also offer up a gloomy caveat. Though they call it a low probability event, the folks at CS fear that if the U.S. soon does slip back into negative growth territory (likely due to policy errors), then we might end up in a depression.

It’s not a happy thought, especially since policy errors aren’t exactly a rarity in Washington. I will add my two cents to the debate by asking the economists to remember just how this recovery was born — with fiscal stimulus and quantitative easing. An inventory replenishment cycle also contributed to our recovery in GDP, but these are hardly sources of sustainable growth. I worry about housing (all the stats — not just today’s — point to renewed weakness in this important sector), job creation, and the increasingly heavy policy hands of our leaders in D.C. I’m also pretty sure that if the U.S. does falter, the Fed will respond with round two of QE. How this all plays out is not an easy call. The only thing we can say for sure about the double dip debate is that if we do have one it certainly won’t be pretty.

— Jack McHugh

Global Stocks End Longest Rally in 11 Months
U.S. Stocks Slide as Home Sales Spur Recovery Concern
BAC-MER- ECRI No Grail (Removed at MER’s request)
Market Focus — Double Dips

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