Double-Dip Fears & the Kennedy Slide

June 18, 2010

Investors in the S&P 500 endured the worst May since 1962 last month, and just like the
Kennedy slide almost five decades ago, the weakness continued into early-June. Then
as now, a young Democratic President from an ethnic minority had been elected on a
populist agenda 18 months previously, but was struggling to make an impact.
Just like today, the public was concerned that the United States was falling behind a
rapidly-growing adversary then, the Soviet Union; today, China. Geopolitical risks
were also rising and fears that nuclear weapons might fall into the wrong hands were
growing then, Cuba; now, Iran.
In a further parallel to today, the stock market enjoyed a powerful recovery the previous
year, as the economy emerged from recession; bullish sentiment and valuation multiples
had reached dangerous levels by winters end, which set the market up for a painful
setback.
The Kennedy stock market correction even endured its own version of the recent flash
crash, as the major market indices dropped almost six per cent on May 29, 1962, and the
exchange couldnt cope with the heavy volume such that the final trade wasnt reported
until two hours and 29 minutes after the market closed.
Just like today, stock market weakness precipitated fears that the U.S. economy might
succumb to a double-dip. Business Week reported that, Wall Street.thinks that the
dramatic recovery in business is over; in fact, some analysts look for a recession later this
year or maybe next year.
Investors began to appreciate that Kennedy, who was elected on the promise that he
would, get this country moving again, was in fact a fiscal conservative just like
Eisenhower, and his confrontation with the steel industry over a price increase, confirmed
suspicions that he would take whatever measures were necessary to throttle inflation. A
repeat of the Eisenhower Administrations record of three recessions in eight years
seemed in store.
The double-dip never materialised and the stock market took off later in the year, once
the Cuban missile crisis was resolved. Unlike today however, stock market weakness
was not accompanied by any detectable stress in the credit markets, and consequently, the
setback proved to be nothing more than a healthy downward adjustment in overpriced
stocks. Fast forward to today, and the drop in stock prices has been accompanied by
widening credit spreads, a sizeable rally in U.S. Treasuries, and the message emanating
from the financial markets is corroborated both by leading indicator indices and analysts
earnings revision activity.
The Economic Cycle Research Institutes (ECRI) weekly leading index growth rate
peaked last October at almost 29 per cent and has since dropped into negative territory,
the first time the index has penetrated zero from above since August 2007. The current
reading is consistent with real economic growth of just one per cent in the second half of
the year too close to double-dip territory for comfort. The signal could be ignored but
for the fact that the six-month rate of change in the Conference Boards leading indicator
and in the six-month rate of change in the OECDs composite leading indicator paints a
similar picture. The message is simple; economic growth is likely to bounce around zero
in the near future.
Analysts optimism has soured significantly in recent weeks, as the ratio of earnings
upgrades to downgrades has dropped from 1.7 to 1.2. The current reading is still above
unity, though the pace of decline is concerning. Regionally, earnings recent revision
activity in the U.S. has seen the ratio drop from 2.1 to 1.4, the ratio in Europe has
declined from 1.8 to 1.3, the Japanese ratio has slid from 1.9 to 1.4, and the current
reading for Asia excluding Japan, at 0.7 is consistent with an imminent decline in
corporate profits. It is clear that global earnings momentum is set to register a
meaningful slowdown in the months ahead and investors would be well-advised to take
note.
It is still too early to state categorically that the cyclical bull market is over, and the
recent move in the S&P 500 back above its 200-day moving average suggests that
investors remain unconvinced by double-dip fears. However, an inflection point has been
reached, and it is highly unlikely that investors will replicate the dash for trash that was
all too apparent last year. The slowdown in earnings momentum, higher credit spreads
and heightened market volatility all suggest that investors preferences will shift away
from low-quality cyclical names to higher-quality issues with relatively predictable
earnings.
The Kennedy slide of 1962 did not spell the end for the economys upward trajectory,
but it did herald the demise of low-quality stocks with dubious prospects, as investors
increasingly emphasised blue-chip names, given their relative stability and attractive
valuations. The same should prove true today given the inviting relative valuations of
high-quality growth stocks, which trade at the lowest price/earnings multiple premium
since the early-1990s. Investors should think quality.

www.charliefell.com

The views expressed are expressions of opinion only and should not be construed as
investment advice.
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