What if…?

As you roll out of bed in the morning, shuffle to the coffee maker and find your way to the shower you glance out the window and notice it’s unusually dark. Just then you notice black clouds, see a glimpse of lightening and hear the rumbling of thunder in the distance. The preparation for the remainder of the day begins with possibilities and judgments of what may transpire. Immediately your thoughts shift to wearing your “not-so” expensive shoes, least favorite suit and where the hell you left that damn umbrella. This is not to say it’s definitely going to rain, nor how bad it will be if it actually does. Even so, like having arrows in a quiver, you want to be prepared.

With all that has transpired (technically and fundamentally) in both the equity and debt markets since mid-July we have to consider, gauge and calculate “What if?” Whether or not it’s just all the talking heads and financial papers trying to make news, the “R” word has been passed around like salt at the dinner table. So again we ask, “What if?” Today’s ‘Jo’ is going to attempt in answering just that question.

Since the late 1940’s there have been 10 recessionary periods – on average one every six years. Recall, a recession is characterized by a decline in real GDP for two or more successive quarters. We have compiled some interesting data about said periods and would like to relate it to today’s market environment.

The first two tables show the periods of recession and correlated equity market downturns for the U.S. economy. As you can see, the length of time of the recessions – defined as the peak to trough months of actual GDP – is 10.3 months*. As for the equity markets (represented by the DJIA – Dow Jones Industrial Average), the average length of declines during such periods is just over one month longer (11.5 months), again measuring from peak to trough. This only makes sense and should be of no surprise that the length of time of an economic downturn and market decline is roughly comparable.

However, the last column of the equity market table above (% market decline for recessionary periods) and the following table created various points of interest and present some relevance when evaluating today.

The first attention-grabbing observation was the average % market decline. Of the last 10 recessions the average downturn was 26%; in essence this represents the traditional definition of a bear market. The second key point comes from the table below - the average number of months the equity market peaked prior to GDP.

In all but one instance - the 1980 recession - the equity market topped, on average, 4 months prior to real GDP topping. Interestingly enough (although not relevant for today’s topic) the equity market’s bottom also preceded the GDP bottom by an average of 3 months. And who said the equity market is not a predictor of the economy? Nonetheless, given this history lesson of past recessions provides some data points to work with.

So for the sake of argument let’s assume the talking heads are correct and we are heading for a recession. If we also assume the mid-July peak at 1,555 in the U.S. equity markets was the top, we are able to do some calculations. Applying the aforementioned numbers from the recessionary tables suggests a potential drop in the S&P 500 Index down to 1,150 (-26%) by June of 2008 (11 months). Basically, another 9 month stint of downward volatility to the tune of 20%, give or take.

Evaluating the data as technicians, we thought it apropos to apply some trend analysis. Below is a weekly chart of the SPX we have posted multiple times in our commentary. We again have outlined the Cyclical Bull Market Trend (BLACK) which began back in 2003. Also outlined is the Secondary Bull Market Trend (BLUE) which was broken back in late July. In mid August, yet briefly, the market re-tested a horizontal support (~1360) dating back to November of last year and March of 2007. As recently as last week the market re-tested the corresponding horizontal and upward sloping resistance around 1,500.

From a technical standpoint the SPX is beginning to form an extremely important topping pattern. However, let us emphasize the word “beginning.” In the coming weeks and/or months if the SPX busts the horizontal neckline of around 1,360 it may have enormous repercussions. This would imply two things. First, if the market broke the approximate 1,360 level and confirmed with a light volume re-test, this would imply the end of the cyclical bull market. Second, from a standard technical point of view, the ensuing drop of a neckline break is traditionally equal distance from the peak of the pattern to the neckline. In this case it is about 195 points. By subtracting the same 195 point from the neckline it corresponds to a massive Floors & Ceilings support (RED) around 1,165. Coincidence or not, this is EXACTLY (give or take a percent) where an average recessionary decline of 26% would put the market.

“What if?” is a question everyone has to ask to be able to properly prepare for any outcome. Some over-prepare, some under and some, believe it or not, don’t at all. Our objective today is to give you a glimpse of the past in hopes to assist you in understanding the future. There are a multitude of factors which have to transpire before the “R” word becomes a reality. However, the skies have turned dark and that possibility is looming. At a minimum one should consider a different pair of shoes. As we have stated in past articles, if the domino’s that have already fallen cause the consumer domino to topple, then the likelihood of today’s analysis unfolding becomes much more probable. Disturbingly this could take some time to materialize. The good news is that more than likely the equity and debt markets will lead the way and in the process provide clues about the health of the consumer - and therefore the economy.

Stay tuned & good luck!

Until next time…

Tuttle Asset Mangement Team

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