Markets Enter Correction Territory As Economic Concerns Escalate (Doll)

by Bob Doll, Chief Equity Strategist, Fundamental Equities, Blackrock

Stocks have endured sustained volatility recently, falling 10% over the last two weeks and dropping close to 5% on Thursday, August 4, the largest one-day decline since 2008. To provide some perspective on what has happened and how investors should view current market conditions, Bob Doll, BlackRock Chief Equity Strategist for Fundamental Equities, offers the following thoughts.

What is behind the sharp downturn in stocks?

While markets have been in an uncertain environment for much of 2011 based on weaker economic data, the current volatility seem to have escalated considerably with the debate and resolution over the debt ceiling issue.

Based on the amount of time spent on this debate and the intense focus that market participants had concerning debt and deficit issues, there was some sort of expectation that the deal that was reached would provide some sort of relief rally, but that did not really happen. When investors took a step back and looked at the deal, it became clear that the long-term debt issues have yet to be resolved and that some hard decisions still need to be made. Investors do not like uncertainty, and being faced with the continued uncertainty surrounding additional rounds of contentious debates over debt issues does not bode well for investor sentiment.

At the same time that these debates were going on, investors witnessed a rash of disappointing economic data. Last week's second-quarter gross domestic product report was much worse than expected and showed that the United States economy has only expanded at around a paltry 1% rate in the first half of the year. That data was followed this week by a weak manufacturing report and disappointing consumer spending numbers, all of which prompted renewed fears of a recession.

All of this also occurred against the backdrop of escalating concerns over European debt problems. Europe is struggling over mounting debt pressures and continues to face significant structural problems in the form of being a region that essentially has a single monetary policy but many fiscal policies. The degree of uncertainty over potential resolution of the sovereign debt problems has been weighing on the markets as well.

On Thursday, August 4, markets began declining sharply, and broke through some important technical trading floors (such as the 1,250 mark for the S&P 500 Index). This prompted a further acceleration in selling, the result of which became the worst day of trading in several years.

What is likely to happen next?

In many ways, markets are in unchartered territory and are facing so many unknowns, which makes it difficult to forecast what will happen next. In our view, however, the key question is what will happen with the global and US economies.

At present, we do not believe that the economy is really facing significant fundamental weakness that would lead to a new recession; rather, the economy is being held back by ongoing credit issues and renewed deflation fears. This may sound like a technical point, but it is an important one, given that, in many ways, the economy is stronger than it was a year ago.

Unlike the market downturn that occurred last year around this time, there are some important differences in the macro backdrop that investors should be aware of. Unlike last year, the growth in the supply of money is positive as is the velocity of money growth. Jobs growth is still weak, but is significantly better than it was 12 months ago (as can be seen by the better-than-expected labor market report issued on August 5). Additionally, bank lending is expanding, a particularly important point for small businesses which conduct a great deal of the hiring in the United States. To this list we would also add the fact that gasoline prices have been falling, which should help provide a boost to consumer confidence and consumer spending. Finally, we would also point out that the supply chain disruptions that occurred due to the earthquake in Japan earlier this year have mostly eased, which should provide a boost to such sectors of the US economy as auto manufacturing.

For all of these reasons, we do not believe that the United States will be entering a recession any time soon. US growth in the second half of 2011 is unlikely to be strong, but we do not believe it will be as weak as the markets are currently predicting.

What are some potential catalysts for improvement?

The risks to the economy and the market are well known, but it is equally important to recognize that there is also a list of things that could "go right."

First, we would expect to see the trend of economic data moving from negative to mixed. We've been saying for some time that we expect the economy to "muddle through" and we do expect to see some positive surprises in the economic data. The July employment report was stronger than expected, so perhaps that represents the start of this trend.

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