Equity bear market and renewed decline in Treasury yields have much further to run

With a 20.3% decline from its October 2007 peak, the Dow Jones industrial average is now officially in bear market territory. The Standard & Poors 500 stock index is not quite there yet with a 19.3% drop from last year's peak. But with so much depressing the economy, increasing job losses, high oil prices, negative investor sentiment and the deteriorating outlook for corporate profits, a parallel decline in the S&P and other stock market indices appears virtually inevitable. Indeed, various market measures and history indicate there is far worse to come.

This does not rule out a temporary "dead cat" equity market bounce after the outsized June price drop, which has triggered some renewed buying interest from bottom fishers. But, even such a brief and misleading rally is open to question. Three quarters of New York Stock Exchange issues have fallen below their 200-day moving average price level, typically an ominous sign of significant technical weakness and of simply more selling than buying. That is certainly understandable considering that there are increasing reports that working Americans are cashing out their retirement savings in a last ditch effort to just meet basic needs or save their home from foreclosure. In the cashing out process they are puting downward pressure on equity prices. And they are not alone. Equity markets around the globe are also evidencing downtrends.

What does history tell us about equity market prospects from here, after prior stock indices fell into bear market territory. There have been nine cyclical declines in the Dow that exceeded 20% since 1960. They ranged from a mild 21.1% decline in 1967, to a severe 45.1% plunge in 1973, with a mean of 33.1% and an arithmetic average for all nine drops of 31.1%. In duration the bear markets averaged 14 months versus the 8months since the current bear market's October 2007 peak. If it is assumed that the extent and duration of this bear market will just match the arithmetic average, it is not too late to raise cash or liquidate losing holdings, which you can buy back later at lower prices. An alternative would be to hedge or neutralize your long equity portfolio with a short position in an exchange traded fund such as the proshares S&P 500. Of course, for the more agressive investor, a naked short position in such a fund is consistent with the outlook suggested by past experience.

There are reasons to be concerned that the bear market decline this time could be worse than the average decline and closer to the deepest of these post-1960 prior bear markets, the 45% 1973 decline. Like the current bear market, that decline was triggered by a steep rise in oil prices, concerns over adequate oil supplies and a plunge in the sales of gas guzzlers. In addition, the current equity market downdraft also reflects the worst housing market since the great depression, a credit crunch, a contraction or deleveraging of the financial community and their desperate effort raise new capital, an appropriate increase in investor caution and a pronounced financial squeeze on consumers and business.

Last Thursday's reports make it clear that the US unemployment situation continues to deteriorate. Nonfarm payrolls declined 62.000 in June, matching the revised 62,000May decline. But the decline in the private sector was steeper, mitigated by a rise in government employment. The unemployment rate remained at 5.5%, validating the sharp rise the month before. Initial claims for unemployment benefits in the latast week rose just above the 400,000 level that has historically been used as a rule of thumb demarcation line ushering in a recession. Long term unemployment and the duration of unemployment continue to worsen. But those statistics would be far worse if they included the large number of unemployed who took part-time work at lower pay only because they could not find full-time employment. The PMI report indicated that the service sector is now contracting. Though the PMI report for manufacturing edged above 50, that is almost certainly temporarily.

While signs of incipient or actual recession continue to abound, so do signs of inflatiom. That combination, along with other problems, has contributed to a rise in corporate and municipal bond yields, especially lower quality credits. The widening quality and steepening maturity yield curve is a typical early onset of recession development. There has also been a steepening of the Treasury maturity yield curve. As the recession deepens, cutting demand for goods and services, especially when the recession becomes global, undercutting the demand for oil and other key commodities, both inflation and inflation expectations will moderate. With that development, long term yields, especially for Treasuries, will decline. The decline in long-term yields for lesser credits and the narrowing in the quality yield spread is likely to await the first signs of an improvement in the economy, suggesting a coming strengthening of those borrowers credit worthiness.

Though the ECB firmed this past week, comments suggested that it was not the beginning of an extended firming trend. That is certainly understandable given growing signs that Europe is headed for recession as well. That will make it easier for the Fed to maintain its current 2.0% funds rate or even ease further as the US recession deepens.

Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport New York 11731

E-mail address: philipbraverman@Gmail.com