Next Up: S&P 500 to 1200

By Dr. Duru written for One-Twenty

March 9, 2008

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OK. OK. OK. Enough already. I now accept that the U.S. economy is either in a recession or heading into one.

Ever since I scoffed at Caterpillar's recession warning last October, I have maintained that we are more likely to enter a slow growth period than a period of economic contraction. I also said that I could not hop on the recession bandwagon until the employment picture took a notable turn south. On Friday, we bought ourselves a ticket south with an ugly jobs report. Not only did the U.S. lose a significant amount of jobs (65,000), but it was the second month in a row of job losses and the largest monthly decline in five years. The Department of Labor also revised its job numbers downward for the last several months.

Even lame duck President Bush had to admit that "it's clear our economy has slowed." But never fear folks; he went on to conclude: "So my message to the American people is this: I know this is a difficult time for our economy, but we recognized the problem early, and provided the economy with a booster shot. We will begin to see the impact over the coming months. And in the long run, we can have confidence that so long as we pursue pro-growth, low-tax policies that put faith in the American people, our economy will prosper." Indeed, President Bush signed a growth package into law a whole three weeks ago. As you know, one of my on-going concerns with America has been that this generation's prosperity has been bought at a high price of debt and low savings. True to form, part of the economic rescue package relies on stuffing our pockets with our own tax money and converting it directly into new and incremental consumption. Bush instructs us that "the growth package will provide tax rebates to more than 130 million American households...And when the money reaches the American people, we expect they will use it to boost consumer spending..." Nevermind paying down your current heavy debtload - more spending continues to be the cure for everything.

Anyway, if history is any guide, we know that over the long-term, the average American will be just fine. So, it is very easy to respond to current troubles with cheery references to a brighter future. Since we must take care of our business in the here and now to get to that better future, let's take a quick look at where we stand with the U.S. stock market.

In January, I set a target low of 1200 for the S&P 500 for 2008. The S&P 500 started the year 2005 at 1200. It also jumped around 1200 until finally breaking out that Fall. At the time I wrote in January, 1200 represented another 10% drop after the S&P 500 had already dropped over 15% from its 2007 and multi-year high in just 3 months. Given the recent headlines (more to come on that), I am even more convinced that we will hit that target, and perhaps sooner than later. Interestingly enough, Louise Yamada uses a "measured move" to come up with her own target of 1200 for the S&P 500 during a recent visit to CNBC's Fast Money. On Thursday, John Roque (Senior Technical Analyst and Managing Director of Natixis Bleichroeder) argued for a target low of 1236. This represents the lows from 2006. If we do stop there, I will say "close enough" on my 1200 target.

A lot of pundits, analysts, and everyone in between have been scoping the January lows like hawks. Everyone is naturally asking whether they will hold, especially now that we are hovering directly above them. This is the same question and the same analysis we get each time some important low gets tested. We should now have plenty of experience with this whole routine. Let's first recall that on January 28th, I expressed skepticism that the January lows should be blamed directly on Societe Generale's rogue trader. Given that we are right back at those levels, it should now be clear that Societe Generale's drama accelerated the motion of the market, but this drama was not a direct reason for the market to hit those lows. We witnessed a black swan type of an event that scared a lot of people into unloading their positions ahead of schedule and involuntarily. In other words, the sellers back then were weak hands looking for some excuse to sell. Without the black swan catalyst, maybe it would have taken us another few weeks or so to hit those lows. Ironically, the rogue trader also became an easy excuse for bulls to start buying to nail those lows; after all, how could one trader take down an entire planet's financial system, right?

The big thing missing from this retest of the January lows? A spike in the VIX. In fact, you could say there is an amazing lack of fear here. It is as if "everyone" expects a successful test of the January lows; folks are waiting to buy instead of itching to sell. This makes me think that a break of the January lows will initiate a renewed violence in the selling that will take us to 1200 quite easily and quite quickly. Back on Jan 28th, I took a tour of the VIX over our last four dramatic spasms of selling to determine whether we could learn any lessons. Here is the summary from that review:

  1. We see confirmation that some kind of near-term bottoming process occurs in the S&P 500 when the VIX spikes. No surprise there.
  2. One spike is not sufficient to mark a bottom. That is, the appearance of a spike in volatility does not prevent another spike from occurring shortly thereafter. The March low came after three spikes in volatility occurred in the span of less than three weeks.
  3. The absolute low does not need to occur on the highest spike in volatility during the bottoming process. This is what happened in November.
The short-term bottoms are occuring closer and closer together and each has had a slightly different signature. I suspect this is because so many people are watching the VIX as an indicator that we get conflicting battles between folks who are trying to anticipate the VIX signal and folks who are trying to wait it out. The chart below shows we do not yet have a spike in the VIX. In fact, we are only back to levels where the VIX has spent about 50% of its time this year.


Since the last spike was just 6 weeks ago, we could group all this time as one long bottoming process. If so, then like November, perhaps we can create/retest a bottom without a higher number on the VIX than the 36 in January. I for one do not think this is the good risk/reward move. The intermediate up-trend in the VIX is still well-intact. Until the trend is broken, I believe that we should continue to expect higher levels of volatility...and lower stock prices. One small sliver of hope: The VIX is finally back to the levels we saw from 1998 to 2003, so perhaps we can look forward to some stabilization in the near future.

A lot hinges on catalysts now. So far, there has been precious little good news to give folks reasons to buy and cling on for dear life (I have done some nibbling for the long-term account on "recession-ugly" names, but I fully expect to add more at even lower prices). Typically, the market hits a bottom once folks start anticipating the rebound in the economic worries that are generating all the selling. The Fed has tried and tried to provide hope, but the market fades each move. Now, it seems every time Bernanke talks, folks sell just in anticipation of a market fade. I find it hard to imagine that the next Fed meeting on March 18th will be any different. In fact, it could be worse: there is nothing new the Fed can tell us to provide hope, and there is plenty of room for worse news. For example, the Fed could admit to us that the economy continues to detereorate and that it will push out its expectation of a return to "modest growth" to 2009. Or the Fed could tell us that it thinks interest rates are low enough for now and that inflation is getting too hot. This message would be the worst because it would mark an official end to the current fantasy that inflation expectations are contained, and the official beginning of stagflation worries. Finally, we continue to hear large and important companies tell us that business is just fine, especially outside of the U.S. So, it is hard to argue that things cannot get much worse. In other words, the news is bad, but it is not horrible. Perhaps at 1200, we will have "horrible."

Be careful out there...and chiru!

DR. DURU®, 2008