The Definition Of A Market Correction Is A 10% Decline

Category: Finance, Financial Planning.

The Dow, S& P and NASDAQ are touching their lows for the year, down some 8% - 9% . A 20% decline is to be expected if there is a moderate recession or the expectation of one.

The definition of a market correction is a 10% decline. Are we headed for a recession? Housing, jobs account for, and related 10% of our total employment. Let s review the economic facts. Single family housing starts fell 3% in October and permits dropped 6% , to the lowest levels in 15 years. (You can see the ripple effect on the earnings of Home Depot and Lowes. ) New housing starts have fallen for almost two years. On top of this, the value of existing homes is declining, creating a( true) feeling of less wealth and limiting the use of home equity loans to monetize residential real estate.

Every time in post- war history housing has declined for two years, it has been accompanied by a recession. Even if the equity is there, home- related lending standards are tightening, making it harder to get home- equity and new home loans. Is this a vicious circle? Tight credit keeps buyers out of the market further slowing new home building and existing home sales. Add to this some$ 350 billion of adjustable rate mortgages which are due to adjust in 200 Most( all? ) of these mortgages will adjust upward. Under the best case scenario, this will take money out of consumer s pockets. Many are two year adjustable mortgages which are arriving at their first adjustment- from that attractive low rate to a healthy premium over LIBOR.

The worse case is much worse. But wait, the Fed can, you say solve this problem by lowering interest rates. Thus far, tightening credit has been limited to the residential market but we now see signs of it spreading to auto loans and credit cards. It s true, the Fed Funds rate can be reduced and interest rates should follow( although not necessarily LIBOR- based loans) but a rate cut will not impact lending standards. The Fed is predicting modest growth for 2008, in the 8% - 5% range( the low end suggests the economy is operating at dangerously close to stall speed) , and continued growth beyond. If financial institutions keep tight lending standards, its the same as a tight money policy regardless of what the Fed does.

There are economic bright spots: exports, technology and farming. (Although, let s also not forget the potential for high energy prices to disrupt the economy. ) Black s Friday s retail sales were encouraging and inflation is in check. Strong exports and technology sector sales cannot overcome a slowdown in consumer spending. However, the consumer accounts for about 70% of the economy. Economists like to point out the resiliency of the U. But, it doesn, in this instance t mean we will avoid a recession, it means we ll come out of it and keep growing afterwards. S. economy and they re right. The problem with recessions is that they re hard to predict.

We won t know we re in a recession until we can see it in the rear view mirror. The old saying is that the stock market has successfully predicted ten of the past five recessions. By then we ll be in it or, coming out of, hopefully it. Is this the capitulation which signals a market bottom or will there be another 10% downward movement to reach the 20% decline typical of recessions? The stock market is in its second major correction of the year and sentiment is decidedly negative. The honest answer is- who knows?

So, let s look at the risk/ reward for stocks and bonds and make some decisions. But, that s not an acceptable answer for an investor who needs to know what to do with his or her money. The S& P is currently selling at about 15x estimated 2008 earnings. A market selling at under a 15 price/ earnings ratio is attractive. This is a reasonable valuation. Even if 2008 earnings estimates are 10% too high, the market moves from being undervalued to fairly valued. So the risk/ reward is 10% downside. 20% upside.

If we avoid a recession, earnings and multiples suggest a 20% market rise. This is why long term investors should stay in the market. As for fixed income investments, let s use US Treasuries as our proxy. Focus on the companies doing the best- large caps with foreign sales. You certainly want to stay away from riskier bonds until the credit mess sorts itself out. Why subject yourself to the uncertainly of inflation and other risks over the next decade for such a low return? Five year Treasuries currently yield 5% ; 10 year yield 0% .

These aren t attractive yields given money market fund and bank deposit rates in the 4% -plus range. You re better off in cash than bonds.

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