John Hussman: The Recognition Window
John Hussman of www.hussmanfunds.com puts out a Weekly Market Comment (which I highly encourage you to read every week). Per usual, this is another good article.
The Recognition Window
Sep 6, 2010
John P. Hussman, Ph.D.
Last week's stock market advance clearly reflected relief over an uptick in the ISM manufacturing Purchasing Managers Index (which advanced slightly to 56.3) and fewer employment losses than expected in the August report. Still, the market's reaction was selective from the standpoint of economic data, reflecting the tendency to seize on any piece of comforting news. Objectively, last week's data was mixed at best, as the broader-based ISM services PMI dropped from 54.3 to 51.5, paced by less growth in new orders, and a shift to contraction in the employment component. The U6 unemployment rate, which includes discouraged workers, moved up to 16.7%. Total hours worked were stagnant. New unemployment claims also remained high, at 472,000, though down slightly from the upwardly revised 478,000 claims the previous week (initially reported at 473,000).
The elevated focus of investors on small bits of news is palpable, and can be observed in the recent series of days where more than 90% of stocks have been either up or down. These strong responses to day-to-day news are somewhat understandable, because a further economic downturn is not well-priced into the market, and would most likely prompt a whole host of policy dilemmas. News that appears to reduce that risk is met with relief and short-covering, while news that validates economic concerns causes a spike in risk aversion.
Over the course of the market cycle, one of the primary areas of risk for stocks (and conversely, one of the best periods for Treasury bonds) is typically the "recognition window" where economic activity begins to deviate from the upward trend that is priced into the market, and investors begin to recognize that an economic downturn is, in fact, likely. In my view, the instant relief provoked by the manufacturing PMI and the employment report was an overreaction to data that is still very early in that window. The typical lead times between deterioration in reliable measures such as the ECRI weekly leading index (and several of our own measures) and deterioration in "coincident" economic activity tend to be on the order of 13-26 weeks. For most economic indicators, we are not there yet. This is why I emphasized two weeks ago that "the much earlier deterioration in economic measures is not encouraging, but it also opens up the possibility that we may see some misleading 'improvement' in the data in the next few weeks before we get into the more typical window of deterioration."