Overblown Recession Fears May Lead to Stock Market Opportunity

Wednesday, May 14, 2008

The first quarter of 2008 was one of extreme pessimism in the stock market. The main fear was that the problems in the financial sector caused by the collapse of the mortgage securities market would lead to a widespread contraction in credit and cause a recession. High oil and gasoline prices and rising inflation didn't help the mood. The Standard and Poor's 500 Index, the generally accepted benchmark indicator of the stock market, declined 9.9% for the three-month period, its worst quarterly performance since the third quarter of 2002.

Many of the chatterers and pundits in the financial news media had been saying for some time that the U.S. economy was already in a recession. A recession is when the total output of goods and services produced by the economy declines (or "recedes") for two consecutive quarters. This measure is called Gross Domestic Product, or GDP. The rate of growth in GDP has slowed over the last two quarters but it has not declined.

The long term average quarterly change in GDP is about 3%. GDP increased 3.8% and 4.9% in the second and third quarters of 2007 before slowing to a 0.6% increase in the fourth quarter of 2007 and the first quarter of 2008. But those are still increases in output, so the U.S. is not in a recession.

Bad news and dire predictions sell better in the financial media garnering more attention than bland good news and bringing in more advertising revenue. What the media was playing off of, in part, was pessimism among consumers over rising prices for gasoline and other necessities like eggs and milk. Politicians running for office also tend to accentuate the negative so you'll elect them to solve your problems. These things make us feel like times are bad even though the country's wealth is increasing.

If the economy does slip into a recession, it's likely to be shallow and short, perhaps just the two quarters needed to define it. The feared general credit crunch hasn't happened. Financial firms who borrow using mortgage backed securities as collateral have had a tough time finding lenders but other borrowers don't seem to be having a problem. Over the past seven months commercial and industrial loans have increased 26% and real estate loans from commercial banks have increased at a 9% annual rate.

Consumer spending, which accounts for 71% of GDP rose 8% in the first quarter and the income tax rebate checks coming out should have a positive, if short term, effect on it over the next couple of quarters. Net exports have been booming thanks to the weaker dollar and continued to do so in the first quarter. Business investment declined only slightly. The main weak spot in first quarter GDP was housing. The slump in housing had trimmed as much 1% off GDP in previous quarters, but its problems haven't spread to other sectors of the economy and the recent data seem to indicate that the severity of it may be easing.

The stock market looks ahead several months and even though it can get overly optimistic or excessively pessimistic, it's a decent leading indicator of economic activity. Since the end of the first quarter (through May 13), the S&P 500 has moved up 6.1% cutting it's year to date loss by more than half.. The panicky outlook that led to the decline in the first quarter is giving way to cautious optimism. While some minor setbacks are sure to occur, the likely result will be that stock prices will continue to work their way higher over the coming months.

David L. Riggs

Managing Investment Advisor