Publié par : crise2007 | décembre 2, 2007

The Bernanke Put and the Last Legs of the Stock Market Sucker’s Rally

 The Bernanke Put and the Last Legs of the Stock Market Sucker’s Rally


 Nouriel Roubini

How sharply will the US stock market fall if the US experiences 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.


To take a longer and more analytical perspective notice that typically a sucker’s rally always occurs at the beginning of an economic slowdown that leads to recession. The first reaction of markets to a flow bad economic news is usually a stock market rally based on the belief that a Fed pause (like the rally following the August 2006 Fed pause) and then possibly easing will rescue the economy. This rally  always ends up being a sucker’s rally as, over time, the perceived beneficial effects of a Fed ease meet the reality of the investors realizing that a recession is coming and that the effects of such a recession on profits and earnings are first order while the effects of the Fed easing on the economy and stock market are – in the short run of a recession – only second order. That is why we had several sucker’s rallies this fall  every time the Fed eased rates or surprised markets with greater easing than expected or signaled to markets that it would ease ahead (as on Wednesday).  But, as the continued flow of poor macro news increases the probability of a recession, the equity markets do and will – in due time – sharply fall when wave of news and macro developments hits hard a weakened and vulnerable economy; then you will see a serious bearish market in equities. So, equities came under pressure in July and August when macro and credit news turned very negative; they rallied after the August 16th and September 18th Fed surprised; and turned into a negative 10% after October 9th when macro and credit news became awful again.


It is well known – from basic macro theory – that the equity market reaction to poor growth news is ambiguous. Lower than expected growth lead to a higher stock market value via the “interest rate channel” and to a lower stock market value via the “profits/earnings channel”. The former effect derives from the fact that bad economic news increase the probability that the Fed will ease monetary policy and thus stimulate the economy, demand and profits. The latter channel derives from the fact that slower growth – or even worse an outright recession – will lead to lower demand, lower revenues and lower profits. Indeed, as stock prices are forwards looking and equal to the discounted value of dividends where the discount rate is related to an appropriate measure of interest rates, bad growth news affect the numerator and denominator of the ratio of dividends to the appropriate discount rate. Usually, the first effect dominates at the beginning of an economic slowdown – when the likelihood of a slowdown is high but the likelihood of a true hard landing or recession is still low and unclear: then the interest rate channel dominates the profits channel. But once the signal of a hard landing or recession become clearer and the likelihood of such hard landing much higher the profits channel dominates the interest rate channel.

Why is this conceptual discussion important? Now that the likelihood of a recession has increased – even in the eyes of otherwise soft landing analysts – one is starting to hear and read with increasing frequency some Goldilocks statements such as “a hard landing will be good for stocks” or “the stock market will rally during a recession” or “the Fed will rescue the markets during a recessionary hard landing” or « P/E ratios are low and earnings yields are much higher than bond yields, thus the stock market is now undervalued ».

To clear the air from the spin that one is increasingly hearing it is useful to ask a simple factual question: what is the relation between stock markets and recessions? So, for a moment, let us leave aside the issue of whether my recession call is correct or not. And let us assume, for the sake of the pure logical argument, that a recession is coming and then ask the question: if we will have a recession, what will happen to the stock market? So, you do not have to believe in a recessionary hard landing to consider this specific question. You just need to ask yourself the simple question of what happens to stock prices when recessions do come.

Luckily we have enough data from previous recessions and stock prices to give an answer to this simple question. Consider the charts that are shown below. They present the percentage change in that S&P500 index around the last six U.S. recessions (i.e. starting with 1970), i.e. in the months before the start of a recession, in the months during a recession and in the months after it. The vertical lines in each charts represents the peak of the business cycle (i.e. the beginning of a recession) and its trough (end of a recession). On average the stock market does not change much between the peak and the trough of the business cycle: on average the fall is only 0.4% between peak and trough; in some recessions – such as the 1974-1975 one – the peak-to-trough fall is much deeper (-13%) but in others – such as the 1980 one – stock prices actually rose 5.8% between peak and trough; so -0.4% is an average for all recessions.

This may seem like a relatively small adjustment but the peak-to-trough comparison is deceptive. It is deceptive because, usually, the stock market starts to fall before a recession starts (i.e. before the business cycle peak), then it falls very sharply during the first stage of a recession, and then in starts to recover in the late stages of a recession before the recession has reached its bottom (i.e. before the trough of the recession). Specifically, the stock market falls from the peak in the business cycle to its lowest level during a recession averages 17.5%; and in every one of these six recessions you have the same pattern: initially stock prices sharply fall as the economy enters a recession. Then, the recovery of the stock market starts before the trough of the business cycle has occurred, i.e. before the economy has gotten out of a recession.

Notice also that, in most episodes, the stock market peaks a few months before the actual start of the recession and starts falling even before the formal start of the recession (i.e. before the peak of the business cycle). Since stock prices almost always start to fall a few months before the recession has formally started – as signals of an impending slowdown and possible recession are already mounting even before a recession is formally triggered and thus priced in the stock market – the cumulative fall in stock prices from their pre-recession peak to their bottom level in the actual recession is well above the 17.5% figure for the stock price fall from the start of a recession to the lowest level of such stock prices during a recession. This average fall in stock prices from pre-recession peak to into-recession bottom is actually close to 28%, an extremely severe and sharp bearish downfall.

In other terms, the peak-to-trough average flat behavior of the stock market hides a much sharper fall in the stock market before a recession and during the first half or so of a recession, followed by a relatively sharp recovery in the late stages of a recession. This pattern makes total sense as equity prices are forward looking and, at any point in time, they reflect all available information about the expected path of current and future dividends/earning and interest rates. The stock market starts to fall before a recession has formally started because the closer you get to the peak of the business cycle when the macro news on growth become increasingly weaker, the higher is the probability that a recession will occur and will thus drag down profits. So, a forward looking equity market peaks before the peak of the business cycle and starts falling before the actual recession has started. That is why stock prices tend to be a good – if imperfect – leading indicator of the business cycle.

The fall in the stock market from the peak of the business cycle to the market lowest level in the recession was 21.0% in the 1970 recession, 33.88% in the 1974-75 recession, 10.6% in the 1980 recession, 18.2% in the 1981-82 recession, 14.6% in the 1990 recession, 10.3% in the 2001 recession. In most recession, as discussed above, the stock market peaks before the recession and starts to fall even before the recession has formally started. In the 1970 episode the stock market peaked 9 months before the recession and fell 12% even before the recession started. In the 1974-75 episode, the stock market peaked 12 months before the start of the recession and fell 23% even before the recession formally started in December 1973 with a good half of this pre-recession drop right after the beginning of the Yom Kippur war that led to Arab oil embargo. An exception is the 1980 episode when the stock market was actually rising in the few months before the start of the recession in February 1980. In the 1981-82 case, the stock market peaked four months before the onset of the recession and then fell already about 4% before the recession actually started. In the 1990 case, the stock market peaked two month before the recession and fell about 2% before the formal start of the recession. In the 2001 episode, the S&P peaked about seven months before the start of the recession in March 2001 and then fall by 31% even before the recession started (the peak of the Nasdaq was, of course even earlier, in March 2000 a full year before the formal onset of the recession).

Of course, in the economic history of the US in the last few decades sometimes stock prices have fallen and a recession has not materialized, i.e .stock markets are not a perfect and uniquely correct leading indicator of a recession. But, and this is more important in the context of the question asked above, any time a recession did occur, the stock market actually sharply fell. So, the issue here is not whether the stock market may at times provide false alarms or incorrect signals of the business cycle; of course, as it is well known, it does at times provide false signals. The issue is whether hard landing and beginning of recessions are associated with sharply falling stock prices. And the simple and unequivocal answer is that recession lead to bearish stock markets where the peak in the economy to the trough in the stock market (as separate from the economic peak-to-trough that lags the one of asset prices) is about 17.5% and where the peak-to-trough in the stock market (i.e. the pre-recession peak to the into-recession bottom of the stock market) is about 28%, i.e a very clear, sharp and deep bear market. So, factually hard landings and recessions do lead to falling stock prices and bear stock markets. So, the recent market buzz and chatter about hard landings and recessions being good for the stock market is utter nonsense based on actual data from decades of US business cycles and repeated recession episodes.

Of course, once a recession has triggered a severe bear market, at some point – before the bottom of the recession – the stock market does start to recover. The fact that the stock market recovers before the trough of the business cycle is reach is also logical and based on the forward looking nature of stock prices: even before a recession has ended the rate of economic activity fall tends to increase: in early stage of a recession the first derivative of output is negative (negative growth) while the second derivative shows an acceleration of the rate of economic contraction. In later stages of a recession, the first derivative is still negative but the second derivative shows a slower rate at which the economy is contracting and signals that the trough of the business cycle may be close, i.e. there is incoming light at the end of the recession tunnel. Thus, for forward looking stock prices it is not necessary to wait until the recession is over for such prices to recover: once the evidence is building up that the worst stage of a recession is close to be over and that the trough – bottom of the downturn – will be reached soon (i.e. the probability that the recession will be over soon is increasing) then the stock markets starts to recover: i.e. stock prices reach their trough before the trough of the business cycle.

How about “soft landing” episodes, i.e. episode where a Fed tightening did not lead to an outright recession but rather to a significant slowdown of the economy and then an economic recovery? The only recent episode of a successful soft landing is 1994-95 when a 300bps tightening by the Fed in 1994 did not lead to a recession but rather a relatively sharp slowdown in the economy. Note that, even in that episode, the Fed risked overdoing it and it eased the Fed Funds rate in 1995 when the slowdown appeared as excessive and risking to jeopardize an economic growth that was on the cusp of the internet and information technology revolution of the mid-late 1990s. Note also that, in that episode, the economy was just coming out of a painful recession that, while it formally ended in 1991, was followed by a job-loss and then a job-less recovery in 2002 and 2003; only by early 1994 the economy was showing signs of rapid growth and employment recovery. So, in term of economic cycle, the monetary tightening of 1994-95 was at a very different stage of the business cycle, early-mid recovery and the Fed was just bringing back the Fed Funds rate to a neutral level after its sharp easing during the 1990-91 recession. In terms of the market consequences of such a “soft landing”, the S&P500 fell by 5% between January and December 1994 as the Fed tightening was under way and the economy was starting to decelerate following the monetary break imposed by the Fed. Thus, while the S&P had started to briskly recover after the 1990-91 recession and had double digit return both in 1992-93 and from 1995 on, the soft landing of the economy in 1994 led to a significant fall in the stock market: while the fall in 1994 was modest – about 5% – since the underlying trend in the market index for a sharp double digit annual recovery since 1992 and after 1995, the soft landing of 1994 implied an underperformance of the stock market relative to its underlying trend that was of the order of 17%, i.e. without the soft landing slowdown of 1994 the market could have grown – based on the underlying trend of the S&P – by at least 17%.

What are the potential caveats to the arguments above that a US recession would lead to a sharp drop in the stock market? Some argue that the sharp fall in equity prices during previous recession occurred after long periods in which the market was bullish and sharply increasing; thus, close to a recession P/E ratios were already excessively high and bound to adjust; also the monetary and credit tightening in previous recession squeezed severely profits and push equity prices lower. Instead, it is argued that today’s conditions are very different from previous growth slowdowns: equity prices zig-zagged without much of a strong trend from 2002 to 2005 and have grown modestly since then while earnings have sharply increased given increased profitability of the corporate sector; thus, the argument goes, P/E ratios are now relatively low and valuations are not inflated; if anything, given the surge in earnings valuations are relative low and bound to rise if a soft landing occurs or bound not to fall as much even if a hard landing occurs. Specifically, unless a major credit crunch  leads to a sharp fall in profits and earnings, equity valuations may not be as much at risk in a US hard landing scenario. 

The above arguments require a whole separate discussion of earnings and profits and their likely future trends that will be discussed in another note. For now, let us observe why these arguments are not convincing. First, in a recession revenues fall and both profits and earnings sharply fall; so equity valuations need to take a hit; and while recessions triggered by a credit crunch or a monetary tightening have more severe effects on corporate profits even recessions triggered by the bursting of a bubble – the tech bubble in 2000, the housing bubble today and its consequent credit crunch – can severely affect earnings and thus valuations. In a typical US recession NIPA profits fall by about 20% and corporate earnings fall by more than NIPA profits, closer to 30% plus. Such a drop in profits and earnings has devastating effect on stock prices. Second, recent data on Q3 earnings suggest already a fall in earnings in Q3 of 8.3% relative to a year ago and a fall in earnings relative to Q2. Third, on a cyclically adjusted basis P/E ratios are still very high: since both profits and earnings now look peaky and bound to sharply slow down, P/Es may be still too high once one considers the likely fall in earnings during an economic hard landing. Of course, the fact that valuations have been relative moderate for a number of years may imply that not all stocks will be hit as hard in a recession: many will gradually fall during the economic downturn but others, that have low valuations now and whose earnings would be less affected by a recession, may do relatively better or not as bad as the overall market.  It may also be the case that, on average the stock market will fall by less than the average 285 in a typical recession .Still, it is hard to avoid the conclusion that a recession would be really bad for the stock market. In every previous recession equities have done very poorly and it is hard to make a logical or empirical argument why in the next recession things would be meaningfully different.

Finally, notice that the equity valuations of homebuilders, financials, and discretionary consumption firms have already followed the pattern that I described above: sharp fall in earnings followed by a sharp fall (about 20% or more in equity valuations).

The discussion above clarifies what one should expect if – as I have predicted – the US slowdown accelerates into a recession: based on historical experience the stock market is likely fall sharply by about 28% from peak to the trough of the equity market before it is starts to recover in the late stages of the recession. So beware of the large amount of spin that is being peddled today by bulls that are now starting to recognize that a recession is likely: they need to spin the bad news about the economy as suggesting that such bad news are actually very good news for the stock markets or that the Fed will be able to prevent such a recession. For these perma-bulls good economic news are very good for the stock market and bad economic news are also very good for the stock markets as the reaction (“I guess it is probably a buying opportunity”) to my recession call by the Squawk Box anchor interviewing a while ago suggests. But savvy investors will not let themselves to be fooled by such non-sequitur arguments and will cautiously adjust their portfolio to reduce the risk of being stuck in a bear market when the recession actually gets under way.







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