The next shoes to drop
Oct 11, 2011
The US economy is definitely in recession and the recession will probably extend into next year. This isn’t necessarily a reason to be concerned about downside risk in the broad stock market, because the stock market attempts to discount the future and might already have priced-in the sort of earnings decline that a recession would bring about. The reason to be concerned about downside risk in the stock market is that the recession is not widely recognised and most analysts are still projecting growth in earnings over the next 12 months.
Earnings forecasts suggest that even though indicators of stock market sentiment reflected extremes of fear and/or pessimism at times over the past two months, the longer-term outlooks of most investors are too optimistic. There’s a good chance that analysts’ estimates and investors’ expectations will be forced downward over the months ahead, leading to a sequence of declining tops in the senior stock indices.
Widespread realisation that 2012 earnings will be lower — perhaps much lower — than 2011 earnings could be the next shoe to drop.
While the euro-zone’s sovereign debt dilemma is likely to worsen before another temporary fix is put in place, this issue is losing potency in terms of ability to adversely affect the markets. The reason is that the financial markets have been focusing on it for many months. Of particular relevance, the debt market fully discounted a Greek Government default some time ago and it would be difficult for Greece’s stock market to do much worse than it has already done (for a picture of the carnage, refer to the chart displayed below). Europe’s political leaders are mostly still in denial, but the financial markets have already priced-in disaster. Only the fine details of the disaster are yet to be ironed out.