Post by jeffolie on Nov 29, 2007 15:49:09 GMT -6
Nouriel Roubini's Global EconoMonitor
The Bernanke Put and the Last Legs of the Stock Market Sucker's Rally
Nouriel Roubini | Nov 29, 2007
How sharply will the US stock market fall if the US experiencees a recession? Given the recent flow of very negative macro news, the likelihood of a US hard landing has sharply increased; thus, it is important to assess the implication of such growth slowdown, hard landing or outright recession on the stock market.
It is true that in the last two days the US stock market has recovered sharply after a significant 10% downward correction in the period from early October until Monday. But the most sensible interpretation of the upward move on Tuesday and Wednesday this week (in spite of an onslaught of lousy macro news: consumer confidence, existing home sales, Beige Book, fall in durable goods orders, regional Fed manufacturing reports, initial claims for unemployment benefits, expectations that Q4 growth will be closer to 0% after the revised 4.9% in Q3, sharply rising credit losses, falling home prices and a worsening housing recession, etc.) is that this is the last leg of a sucker's rally (or dead cat's bounce) driven by wishful hopes that the Fed easing will prevent a recession.
Certainly yesterday Wednesday equities rally was totally driven by Fed governor Kohn signaling the obvious, i.e. that given that the liquidity and credit crunch is now worse than at its August peak the Fed will cut rates in December, January and for as long as needed. In this game of chicken between the Fed and the bond market (with the latter signaling already for a while that the Fed will keep on cutting) the Fed was obviously the one to blink: this was no surprise to anyone who had noticed the meltdown in financial markets (a ugly liquidity and credit crunch) in the last few weeks. But for some reason the stock market on Wednesday discovered what analysts, the bond market and credit markets knew all along, i.e. that the Fed will have to keep on cutting rates as we are headed towards an ugly recession that is now inevitable regardless of how much the Fed cuts rates.
The behaviour of the stock market since last August can be best interpreted in terms of a Bernanke Put, i.e. the stock markets' hope that a Fed easing will prevent a hard landing of the economy. The August liquidity and credit shock severely tested the stock market downward; then you had a first sucker's rally on August 16th when the Fed announced the switch from a tightening bias towards an easing bias. A second phase of this sucker's rally occurred on September 18th when the Fed surprised the markets with a 50bps Fed Funds rate cut rather than the 25bps that the market expected. Then equities kept on rising, in spite of worsening economic and credit news, all the way until October 9th. Then, a drumbeat of weaker and weaker economic and credit news started to take a toll again on the stock market and triggered the beginning of the stock market correction (10% fall in stock prices) that continued until last Monday November 26th. A third phase of this sucker's rally occured after the Fed cut rates on October 31st triggering another stock market rally that turned out to be brief as a bombardment of awful credit news and weak economic data pushed down the market again.
The current leg of the sucker's rally was on Wednesday - with stock prices sharply up - when Kohn effectively signaled to the markets that - in spite of all the Fed rhetoric to the contrary in the last few weeks - the Fed would ease rates in December and for as long as needed to deal with the liquidity and credit crunch and to avoid a recession. In each case in the last few months the stock market has rallied when the Fed has signaled a willingness to ease monetary policy to avoid a recession.
Call it a Bernanke Put if you believe that the Fed is trying to avoid a financial meltdwon; call it a need to bail out the economy rather than bailing out the markets if you believe - as I do - that the Fed actions are more driven by its concerns about the economy rather than an attempt to rescue investors; call it a moral hazard play if you believe that the Fed is trying to rescue investors and risks to create down the line another asset bubble. You can call it whatever you like but one thing is obvious: the Fed easing is perceived by the stock market as an action aimed to prevent a recession from occurring and stock prices rally - in spite of worsening macro news that are signaling recession ahead - because of the hope - that I will show is only wishful thinking - that the Fed will be able to avoid such a hard landing. Thus, what has been mostly driving up the stock market in the cycles since last summers is Fed policy expectations of easing.
The same pattern of market delusion and serial sucker's rallies occurred in 2001: the economy entered in a recession in March 2001 but the S&P 500 index rallied by a whopping 18% in April and May because the market and investors expected that the aggressive Fed easing - that had started in January - would prevent a 2001 recession (the famed and deluded hope of a second half of 2001 "growth rebound" that never occurred). It was only in June when it was obvious that the economy was sinking in spite of the Fed attempt to bail it out that the stock market started to sharply fall again; so then and again now the onset of a recession led to a typical sucker's rally fed by expectations of a Fed bailout of the economy; and the latest rally this week is occurring while the liquidity and credit crunch in the markets are as bad now or worse than in August and while macro news are worsening by the day.
Indeed the 2008 recession will repeat the Fed cycle and stock market cycle of the 2000-2001 recession: then the Fed tightened rates all the way to 6.5% in June 2000 and kept a tightening bias in July, September, November as it was worried more about inflation than about growth (that had been as strong as 5% in Q2 of 2000 but was sharply deceleraring in H2 of 2000 as the tech boom was going bust). The Fed was totally mistaken then about its assessment of the effects of the tech bust on the economy and kept on worrying about inflation while growth was plunging after Q2 of 2000; it was only at the mid December 2000 FOMC meeting, when the signals were that the holiday sales would be awful, that the Fed suddenly switched from its November FOMC tightening bias to an easing bias. And two weeks later when, after lousy holiday sales data, the NASDAQ fell 7% in its first 2001 trading day on January 3rd the Fed stared to aggressively cutting the Fed Funds rate with a an initial 50bps inter-meeting cut that day. Then, as now you had a sucker's rally following the Fed easings that intensified in April and May 2001 as the Fed kept on cutting rates.
Indeed, not only the Fed got it wrong on the coming recession in the 2000-2001 period; also professional forecasters got it wrong as an Economist magazine poll in March 2001 (when the recession had already started) showed that 95% of such forecasters believed that a recession would be avoided as the aggressive Fed easing would lead to a H2 growth rebound. And, as discussed above, even the stock market got it wrong as the 18% final sucker's rally (or last dead cat bounce) in April and May 2001 was followed by a massive bear market starting in June 2001 as the economy spinned into a deeper recession in spite of the aggressive Fed ease.
continued below
The Bernanke Put and the Last Legs of the Stock Market Sucker's Rally
Nouriel Roubini | Nov 29, 2007
How sharply will the US stock market fall if the US experiencees a recession? Given the recent flow of very negative macro news, the likelihood of a US hard landing has sharply increased; thus, it is important to assess the implication of such growth slowdown, hard landing or outright recession on the stock market.
It is true that in the last two days the US stock market has recovered sharply after a significant 10% downward correction in the period from early October until Monday. But the most sensible interpretation of the upward move on Tuesday and Wednesday this week (in spite of an onslaught of lousy macro news: consumer confidence, existing home sales, Beige Book, fall in durable goods orders, regional Fed manufacturing reports, initial claims for unemployment benefits, expectations that Q4 growth will be closer to 0% after the revised 4.9% in Q3, sharply rising credit losses, falling home prices and a worsening housing recession, etc.) is that this is the last leg of a sucker's rally (or dead cat's bounce) driven by wishful hopes that the Fed easing will prevent a recession.
Certainly yesterday Wednesday equities rally was totally driven by Fed governor Kohn signaling the obvious, i.e. that given that the liquidity and credit crunch is now worse than at its August peak the Fed will cut rates in December, January and for as long as needed. In this game of chicken between the Fed and the bond market (with the latter signaling already for a while that the Fed will keep on cutting) the Fed was obviously the one to blink: this was no surprise to anyone who had noticed the meltdown in financial markets (a ugly liquidity and credit crunch) in the last few weeks. But for some reason the stock market on Wednesday discovered what analysts, the bond market and credit markets knew all along, i.e. that the Fed will have to keep on cutting rates as we are headed towards an ugly recession that is now inevitable regardless of how much the Fed cuts rates.
The behaviour of the stock market since last August can be best interpreted in terms of a Bernanke Put, i.e. the stock markets' hope that a Fed easing will prevent a hard landing of the economy. The August liquidity and credit shock severely tested the stock market downward; then you had a first sucker's rally on August 16th when the Fed announced the switch from a tightening bias towards an easing bias. A second phase of this sucker's rally occurred on September 18th when the Fed surprised the markets with a 50bps Fed Funds rate cut rather than the 25bps that the market expected. Then equities kept on rising, in spite of worsening economic and credit news, all the way until October 9th. Then, a drumbeat of weaker and weaker economic and credit news started to take a toll again on the stock market and triggered the beginning of the stock market correction (10% fall in stock prices) that continued until last Monday November 26th. A third phase of this sucker's rally occured after the Fed cut rates on October 31st triggering another stock market rally that turned out to be brief as a bombardment of awful credit news and weak economic data pushed down the market again.
The current leg of the sucker's rally was on Wednesday - with stock prices sharply up - when Kohn effectively signaled to the markets that - in spite of all the Fed rhetoric to the contrary in the last few weeks - the Fed would ease rates in December and for as long as needed to deal with the liquidity and credit crunch and to avoid a recession. In each case in the last few months the stock market has rallied when the Fed has signaled a willingness to ease monetary policy to avoid a recession.
Call it a Bernanke Put if you believe that the Fed is trying to avoid a financial meltdwon; call it a need to bail out the economy rather than bailing out the markets if you believe - as I do - that the Fed actions are more driven by its concerns about the economy rather than an attempt to rescue investors; call it a moral hazard play if you believe that the Fed is trying to rescue investors and risks to create down the line another asset bubble. You can call it whatever you like but one thing is obvious: the Fed easing is perceived by the stock market as an action aimed to prevent a recession from occurring and stock prices rally - in spite of worsening macro news that are signaling recession ahead - because of the hope - that I will show is only wishful thinking - that the Fed will be able to avoid such a hard landing. Thus, what has been mostly driving up the stock market in the cycles since last summers is Fed policy expectations of easing.
The same pattern of market delusion and serial sucker's rallies occurred in 2001: the economy entered in a recession in March 2001 but the S&P 500 index rallied by a whopping 18% in April and May because the market and investors expected that the aggressive Fed easing - that had started in January - would prevent a 2001 recession (the famed and deluded hope of a second half of 2001 "growth rebound" that never occurred). It was only in June when it was obvious that the economy was sinking in spite of the Fed attempt to bail it out that the stock market started to sharply fall again; so then and again now the onset of a recession led to a typical sucker's rally fed by expectations of a Fed bailout of the economy; and the latest rally this week is occurring while the liquidity and credit crunch in the markets are as bad now or worse than in August and while macro news are worsening by the day.
Indeed the 2008 recession will repeat the Fed cycle and stock market cycle of the 2000-2001 recession: then the Fed tightened rates all the way to 6.5% in June 2000 and kept a tightening bias in July, September, November as it was worried more about inflation than about growth (that had been as strong as 5% in Q2 of 2000 but was sharply deceleraring in H2 of 2000 as the tech boom was going bust). The Fed was totally mistaken then about its assessment of the effects of the tech bust on the economy and kept on worrying about inflation while growth was plunging after Q2 of 2000; it was only at the mid December 2000 FOMC meeting, when the signals were that the holiday sales would be awful, that the Fed suddenly switched from its November FOMC tightening bias to an easing bias. And two weeks later when, after lousy holiday sales data, the NASDAQ fell 7% in its first 2001 trading day on January 3rd the Fed stared to aggressively cutting the Fed Funds rate with a an initial 50bps inter-meeting cut that day. Then, as now you had a sucker's rally following the Fed easings that intensified in April and May 2001 as the Fed kept on cutting rates.
Indeed, not only the Fed got it wrong on the coming recession in the 2000-2001 period; also professional forecasters got it wrong as an Economist magazine poll in March 2001 (when the recession had already started) showed that 95% of such forecasters believed that a recession would be avoided as the aggressive Fed easing would lead to a H2 growth rebound. And, as discussed above, even the stock market got it wrong as the 18% final sucker's rally (or last dead cat bounce) in April and May 2001 was followed by a massive bear market starting in June 2001 as the economy spinned into a deeper recession in spite of the aggressive Fed ease.
continued below