What if the U.S. economy recovered from the mildest recession on record and the stock markets didn't care?

Yesterday's heavy sell-off arrived as yet another economic report promoted the recovery theme. To be sure, the ISM Index rose to 55.7% in May vs. the consensus of 55.0% estimates, or the fourth month in a row in which the index has gained. And while traders initially responded favorable to the report, by the end of the day, every major U.S. stock exchange was swimming in red.

Catching the blame for yesterday's sell off was a Tyco CEO investigation and firing, an El Paso executive suicide, rumors that Williams manipulated energy prices, a Xilinx Inc. earnings warning, and fears of an Oracle warning. Suffice it to say, this deluge of negative news alone was more than enough to take the focus away from the positive ISM data. However, another tidbit also reared its ugly head:

"Auto Sales Drop in May Despite Recovery"   Reuters

No, the above quote is not a typo – auto sales actually dropped by 5.7% in May for the lowest monthly total this year. Although the data could be an aberration, it could also be telling of something far more ominous. As S. Bernstein's Scott Hill points out,

"Maybe the consumer's finally had it".

Suffice it to say, if the consumer has 'finally had it,' then U.S. economy is about to embrace quite the quagmire: if the consumer is tapped out, U.S. corporate profit estimates are dramatically overstated, capital spending will not rebound anytime soon, and the dreaded double dip is just around the corner.

It is worth remembering that the U.S. consumer controls roughly 2/3rds of the U.S. economy. Accordingly, there is not much room for error if the consumer decides to save a few extra dollars for a rainy day. In fact, if consumers begin saving money for a rainy day, as Japan has come to know all too well, this can turn a soft rain into a downpour…

The Warning Signs of Consumer Impatience
I don't particularly think that the conference board's report on consumer confidence is an accurate gauge of how 'confident' the American consumer is. After all, the conference board does not feel it necessary to divulge the financial background of the 3,500 or so respondents to its survey. Moreover, it does not even release how many people respond to each monthly survey (3,500 is the est.) Suffice it to say, those consumers that completely lack confidence are probably feeling so down that they throw the survey into the trash.

That said, last week's consumer confidence survey highlighted an interesting theme – that being that the U.S. consumer is growing impatient. To be sure, those consumers expecting business conditions to improve over the next 6 months dropped in May. You may recall that this gauge was solid during early 2002, while actual confidence (current situation) slumped. Accordingly, if this trend persists, it highlights an important question for investors to consider -- if the U.S. economy is really in a sustained recovery, should not consumers be becoming more confident about the future?

Summing Up Investor Fears
No longer are investor apprehensions focused on interest rates. For certain, Greenspan could put on a funny looking jacket and run around the NYSE floor screaming 'I am going to cut or raise interest rates' and no one would pay any attention to him. Rather, investors are focused on where the next bottom may lay – when the next Kenneth Lay will be exposed – and whether or not the economy can continue laying golden eggs.

With this in mind, the truth is that if the economic recovery does not go according to plan, the U.S. stock markets do not have a 'bottom' per se -- at least not any bottom that can be predicted beforehand. The reason for this is simple: at what price level can it be guaranteed that the markets will hold firm if the economic recovery stalls and/or corporate profits remain anemic? Such is the sum of investor fears: there is no bottom.

Capitulation Not Necessarily A Buy Signal
You may remember that the best thing the markets have had going for them since October 2001 is the fact that the 'bottom was in.' Accordingly, if, and when, the 'bottom' is broken, the markets could see a different kind of capitulation.

'Trading' capitulation occurred in April 2000 and September 2001 – or when the markets careened lower forcefully but buyers stepped in relatively quickly wielding the phrase 'don't panic.'  By contrast, 'psychological' capitulation, which rarely occurs, happened in 1929 and 1837 – or periods when selling became so popular, so fast, that mass panic helped in changing the investment landscape for an extremely long time.

In sum, you don't predict and/or participate in psychological capitulation -- you don't profit from it the day after prices tumble or when prices appear to have stabilized. Rather, you watch as stock prices drop and many investors leave the markets in the following weeks and months as no sustainable rebound occurs. You watch as the character of the markets change because as prices collapsed, so to did the hopes of many investors.

Consequences of Capitulation
If something causes prices to capitulate dramatically lower, the subsequent reduction in wealth and confidence would severely hurt the prospects for an economic recovery. Moreover, given current weakness in the dollar and the growing mistrust investors have for Corporate America, a period of capitulation may be all that is required to turn what is currently one of the longest bear markets ever into the worst bear market ever.

During the recession and bear market, consumers kept spending and investors kept investing (based on % of population). As such, perhaps the most poignant threat of a capitulatory atmosphere is that it would enable many Americans to finally accept a startling revelation:

The stock markets are not a savings account.

© 2002 Brady Willett
Editorial Archive

This article, which appeared as "The Word" June 4, 2002 on www.fallstreet.com is used by permission. Contact: Mr. Willett is author of "Lessons UnLearned."

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