History Shows Stock Market Plunge May Just Be Par for the Course

Although the stock market plunge last week was certainly unsettling, history and a slew of positive leading indicators show that this may just be part of a normal pattern with better news ahead.

Stocks were hammered on Tuesday as a negative revision to an economic report out of China and fears over European bank funding set off a global firestorm of selling. A very weak consumer confidence report didn't help matters.

The major U.S. stock indices fell through critical support levels, with the S&P 500 returning to levels first reached last August. That's almost an entire year of stock market appreciation out the window.

In the end, the Dow Jones Industrial Average lost 2.7%, the S&P 500 lost 3.1%, the NASDAQ lost 3.9%, and the Russell 2000 lost 4%. Large-cap stocks outside the United States fell 3.5%, while emerging market stocks fell 4%. Some of the European exchanges fell the most, including iShares MCSI Spain Index ETF (NYSE: EWP), down 5%, and iShares MCSI Switzerland Index Fund ETF (NYSE: EWL), down 6%.

The S&P 500, as you can see in the chart above, landed at support at the 1,040 level that has held the index over the last nine months. This is the neckline of the big head-and-shoulders pattern we've been talking about. I had expected the right shoulder to be made at 1,040-1,050 but it appears that holders were so anxious to flee the scene of the crime that the right shoulder is a bit stunted.

More disheartening for bulls in the week was the crushing blow suffered by big-cap consumer staples stocks like The Coca-Cola Co. (NYSE: KO) and Pepsico Inc. (NYSE: PEP), down 2%-plus. Procter & Gamble Co. (NYSE: PG) also sank under its 200-day average for the first time since early last summer; last time it crossed below the 200-day was at the start of the rout in September 2008.

Elsewhere in this vein, Colgate Palmolive Co. (NYSE: CL), Pfizer Inc. (NYSE: PFE), Microsoft Corp. (NASDAQ: MSFT), Alcoa Inc. (NYSE: AA), Johnson & Johnson (NYSE: JNJ), Hewlett Packard Co. (NYSE: HPQ) and Cisco Systems Inc. (NASDAQ: CSCO) all declined. Each is now well below their 200-day line and showing few signs of life, as you can see in the chart above (from top, MSFT, PG, AA, PFE, KO). The upshot: Weakness is broadening and becoming pervasive. It's not persistent or profound yet, but it's headed in that direction.

So what's going on? It's not one thing, it's an accumulation. Fears of a second recession are growing more palpable and investors are feeling panicky. The CBOE Volatility Index (CBOE: VIX), which was quiet on Monday, surged 20% Tuesday -- its largest one-day gain since June 4. Investors flocked to perceived safe haven assets like gold and bonds -- in fact, the yield on 2-year Treasury notes fell below 0.6% for the first time. Commodities were hit hard: Copper lost 5.1% and crude oil fell 3%.

Shares of some of the companies most closely tied to the global economic recovery -- were thrown to the ground like penny stocks. Citigroup Inc. (NYSE: C) lost 5.2%, though a mysterious -17% down-spike was excised from the record. Textron Inc. (NYSE: TXT), a defense and industrial conglomerate, lost 10% as it fell out of its 10-month trading range; a lot of other defense contractors such as General Dynamics Corp. (NYSE: GD) and Northrop Grumman Corp. (NYSE: NOC) also look like this, or worse. International Paper Co. (NYSE: IP) lost 6.7%; The Boeing Co. (NYSE: BA) lost 6.3%; Ford Motor Co. (NYSE: F) lost 5.3%.

The market has now fallen into a very oversold short-term condition -- just like late May and early June. Really, I mean it this time. The next move could be mildly down again on Tuesday morning as margin clerks force overleveraged, wrong-footed fund managers to come up with cash to meet borrowing covenants. That usually brings selling in big-cap stocks that have advanced the most, as that is where the vein of accessible profits lie. After that, say around 11 a.m. ET, the market will have a chance to levitate.

The bottom line for me is that the S&P 500 closed the month below its 12-month average. Since 1990, that sort of monthly close has been a rock-solid sell signal. It's the same cross that occurred in October 2000 and December 2007, and I know that a lot of major fund managers use it as a simple but effective cyclical sell signal.

Before we get too wildly bearish, though, let me tell you some important positives and give you some more perspective.


Coming out of the past five recessions (1970, 1974, 1982, 1991, and 2001) increases in the ISM Manufacturing Index, corporate earnings, and consumer confidence all slowed considerably as the economy transitioned from cyclical economic recovery into slower secular economic growth, according to Merrill Lynch analysts.

It's no surprise that stocks don't tend to do much in the second year of recoveries when investors become increasingly worried about the potential for a quick return to recession, sometimes called a "double dip."

Just four months into the strong recovery of 1975, the S&P 500 lost 14% (the current correction has been worth 14% too). Although stocks subsequently recovered and GDP grew 4% in 1976, the S&P 500 didn't make any progress that year. In 1982-'83 stocks surged 63%, but then slumped in 1984 as GDP growth slowed in the second year of recovery, as shown in the chart above. In 1992, stocks only managed to gain 6.6% after digesting big recovery-fueled gains in 1991.

Something similar could be happening right now. Since the recession unofficially ended last July when GDP growth flipped to positive, we're now about to enter the second year of this recovery, so it seems that a slippage in the market is just par for the course. Aggravating, sure. But not the end of the world.

We've sure seen the data points soften over the last couple of months. New homes sales plunged to a 40 year low in May. Lumber prices are down 43% over the last two months. The money supply has stopped growing. Job growth is anemic. Unemployment benefits are about to expire for millions of people after the Republicans in Congress blocked a renewal -- taking $45 billion worth of annual purchasing power off the table. And the ISI Group's company surveys have moved to a 14-week low as business confidence has waned. These are all signs of a slowdown. But ...


.... There are also some promising signs that the economy is on a growth path. These signs don't get as much PR these days, so be sure to equally weight them in your mind.

General Motors (which is eyeing an IPO) announced that it won't have its usual summer production shutdown. Mercedes, BMW, and Audi are all adding staff to boost summer production too. Apartment rents are on the rise. Mortgage rates continue to drop to new record lows, making houses more affordable than ever. Railcar loadings increased 0.6% last week over the previous week and are up 17% from their recession lows. Overseas data has also been strong, with solid employment readings from Brazil, Germany and Taiwan and good industrial production numbers in Singapore.

Moreover, the economics team at the ISI Group in New York notes that wages and salaries have been growing at a 4.1% annual rate over the last five months. Why? Over this period, more than 1.5 million new jobs have been created. The trend is set to continue with the latest Business Roundtable survey of CEOs on their employment plans increasing to the highest reading since 2006.

Overall, Deutsche Bank AG (NYSE: DB) economist Joseph LaVorgna notes that only when the year-over-year growth rate of the Index of Leading Economic Indicators -- which looks at 11 indicators including new orders, average workweek, and building permits -- turns negative should people worry about the economy. Although the three-month growth rate has slowed from a peak of 14% last July, it's still growing at a very fast 7.2%, as shown above. The 12-month rate is down from 11.6% to 9.2% now. All are well above zero.

LaVorgna believes that these growth rates "conservatively imply real GDP gains in the 3.5% to 4% range." Likewise, the ECRI Weekly Leading Index that I have shared with you many times, shows that the economy is slowing down to cruising speed, not crashing.

In short, I realize that with market prices falling so fast lately it's easy to extrapolate out a lot of end-of-world scenarios, but really the picture is not that bleak.


Monday: Personal income continued to grow in May, rising 0.4% over April. Consumer spending also increased. Both are great signs that consumers are slowly regaining purchasing power as the job market slowly starts putting people back to work.

Tuesday: Thanks to an increase in activity from the government's now expired homebuyer tax credit, home prices increased 0.7% month-over-month in April. More recent data on sales suggest May should see another set of price increases before another soft patch is hit as the post-stimulus slowdown forces prices down again. Separately, consumer confidence plunged in June, with the Conference Board's measure falling more than 16% -- a decline of a size normally associated with an economic shock. Much of the decline was due to regional weakness related to the oil spill in the Gulf of Mexico.

Wednesday: The Chicago Purchasing Managers Index indicated business activity continued to grow in June, and new orders are increasingly being put into production. As a result, factory managers are being forced to hire new workers: the employment sub-index increased five points to 54.2. Any reading over 50 indicates hiring.

Thursday: A busy day. Motor vehicle sales fell to an 8.4 million annual rate, down from 8.9 million in the previous month. The ISM Manufacturing Index continues to reflect month-over-month growth in the manufacturing sector, albeit at a slower rates. The index fell to 56.2 in June from 59 previously. New orders fell seven points to 58.5. Production and hiring remained strong. The worst news of the day was the 30% plunge in the Pending Home Sales Index for May -- which suggests that housing is in the midst of a new leg down. The good news was that the Monster employment index increased seven points to 141 in June -- indicating rising online job demand.

Friday: The June payroll report was disappointing. Total nonfarm payrolls fell by 125,000 as the government let all those temporary Census workers go. Removing that effect, private payrolls increased 83,000 for the month following a 33,000 rise in May. That was below analysts' expectations of a 105,000 advance in private payrolls. The manufacturing sector added 9,000 workers for the third straight month of gains.

Also, hours worked and average earnings both fell. The unemployment rate dropped to 9.5% from 9.7% previously, but only due to a sharp drop in the number of people looking for work.

The week ahead

Monday: Markets closed for observance of Independence Day.

Tuesday: ISM Non-Manufacturing Index will provide a look at the level of activity in the all important services sector of the economy in June. Analysts expect the level of activity to increase over May, but at a slower rate of growth.

Wednesday: The Mortgage Bankers' Association will release its latest Purchase Application Index. Expect the results to be weak if recent housing data points are any guide. Earnings reports: Family Dollar Stores Inc. (NYSE: FDO)

Thursday: Chain store sales and initial weekly jobless claims will be released.

Friday: An update on the status of the inventory rebuilding cycle when the government releases the latest wholesale trade data. Inventory rebuilding has been an important driver of economic growth over the past few quarters. Earnings: Elan Corp. plc (NYSE ADR: ELN).