Image: Stock traders
Richard Drew  /  AP
Bear markets and recessions often go together. When companies see bad weather ahead and mark down their profit forecasts, investors take cover and sell stocks.
By John W. Schoen Senior producer
updated 7/14/2008 5:09:33 PM ET 2008-07-14T21:09:33

After a tense weekend that raised further doubt about the strength of the U.S. mortgage market, the stock market drew some reassurance from news that the Treasury and Federal Reserve stood ready to come to the rescue of mortgage finance giants Freddie Mac and Fannie Mae.

But, despite a relatively mild Monday selloff, there was no question that a bear market is well underway, the latest sign that the economy is probably in recession. If history is any guide, both the economy and the stock market have a way to go before they hit bottom.

Stock prices have been near bear-market levels for weeks but officially landed there last week when the broad Standard and Poor's 500 index fell to more than 20 percent below its October peak level. The more narrow Dow Jones industrial average already had fallen more than 20 percent from its latest peak, the standard definition of a bear market.

Bear markets and recessions often go together. When companies see bad weather ahead and mark down their profit forecasts, investors take cover and sell stocks.

But the relationship is not perfect. The market has seen big pullbacks before without the economy tipping into recession; the Crash of 1987 is one of the best recent examples. Conversely, in the back-to-back recessions of 1980-82, one of the worst downturns of the past 50 years, the S&P 500 index was actually higher at the end of the event than when it began.

Over the past hundred years, the average bear market has lasted a little over a year and seen stock prices fall by about 30 percent. By that measure alone, investors can expect stock prices to continue to continue falling.

Corporate profits, meanwhile, are coming under pressure. And because stock prices generally are heavily influenced by corporate earnings, the bear market isn’t likely to end before those profits begin to recover.

That’s why, over the next few weeks, investors will be looking carefully at not only at what companies report they earned in the second quarter, but the guidance they give for the next few quarters. Those forecasts have been getting progressively worse so far this year.

“When we started the year, we thought we would see about a 4 percent increase in earnings for the S&P 500 in the second quarter,” said Sam Stovall, chief investment strategist for Standard and Poor's Equity Research. “Now based on new guidance, additional writedowns and so forth we're looking for closer to a 10 percent decline.”

A lot, of course, depends on how well or poorly the economy performs. Though the latest data show the GDP has turned in small gains in growth, a series of six months of job losses and a five-month decline in industrial production point to an economy that is shrinking.

Merrill Lynch economist David Rosenberg is among those who believe that a recession is already under way.

Major Market Indices

Although the nation's gross domestic product rose 1 percent in the first quarter, according to the government, Rosenberg said in a recent report that he expects that figure to “undergo massive revisions.” When the final numbers are tallied, the results could show the economy began shrinking late last year. Such revisions marked the beginnings of both the 2001 and 1990-91 recessions, said Rosenberg.

Even as economic growth appears to have stalled, higher prices for oil, food and other commodities are fueling higher inflation both in the United States and around the world. That’s forced the Federal Reserve to halt a series of interest rate cuts deigned to keep the economy moving. Central bankers in Europe and elsewhere already have begun raising rates in an effort to curb inflation.

“Stagflation is the word — certainly here in the United States — and it's more or less breaking out all over the world,” said Allen Sinai, chief economist at Decision Economics, referring to the dreaded combination of stagnation and inflation.

“And it's putting central banks in a real bind," he said. "For (economic) growth they need to cut rates, but they can’t possible do that. At the end of the day, central banks have to raise rates to fight inflation.”

Fed officials will get another reading on prices this week, with back-to-back reports on the latest monthly data on wholesale and consumer inflation. That news could place the Fed further in a bind; a reading showing rising inflation would increase the need to raise interest rates to try to tamp down price increases.

But raising rates could worsen the ongoing global credit crisis — including the fragile condition of mortgage finance giants Fannie Mae and Freddie Mac. On the other hand, lowering rates to calm the credit markets risks stoking inflation.

As the latest round of corporate earnings reports are released in the next few weeks, investors are bracing for more bad news as financial giants like Merrill Lynch and Citigroup Inc. are again expected to write off billions of dollars of assets. Since last year, banks have written down nearly $300 billion.

“We have to consolidate, recapitalize and resize the entire financial system,” said Sinai. “It is broken, it is cracked. It will take a long time to fix it. You overlay that on what's going on in the economy, and the recession that we are already in and have been in, and the equity bear market is just going to last with occasional interruptions.”

As they work to rebuild damaged assets, banks are also coping with a big drop in profits. Financial stocks in the S&P 500 last year generated $61 billion of earnings; this year, the number is fall below $25 billion, according to S&P.

With a sizable portion of their assets backed by home mortgages, the continuing decline in home prices will prolong the rebuilding process. And with banks under pressure, they’re lending less money to potential home buyers — which further delays the recovery in the housing market.

"You're going to have further price drop as the value of (banks’) collateral is impaired and the mortgages are held on the banks balance sheets will become worthless," said Kevin Caron a market strategist at Stifel Nicolaus. "So it's a self-propagating negative cycle that is going to be difficult to break, but eventually it will come to an end."

Earlier this year, the hope was that aggressive rate cutting by the Fed, coupled with $107 billion in tax rebate checks, would help the economy dodge a recession. The stimulus plan seemed to have the desired effect. Last week retailers reported better-than-expected gains in sales for June.

But the final checks have been mailed and will soon be spent. Then higher prices and rising unemployment are likely to crimp consumer spending, which accounts for some 70 percent of  U.S. economic activity.

“Discretionary spending of all kinds — restaurants, movies etc. — are going to get scaled way back in the next six months to a year,” said Nariman Behravesh, chief economist at Global Insight. “And that will have a dramatic effect on consumer spending and the overall economy.”

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