Financial Watch

Ever since the Federal Reserve started to raise interest rates in 2004, Financial Watch has cautioned that our massive trade deficit puts the U.S. economy in a position unique to any prior period in our nation’s history. Our nation’s reliance upon imports puts downward pressures on economic growth. Much of the United State’s economic growth in recent years has been fueled by low interest rates. June’s employment report combined with other economic gauges released over the past week confirms the U.S. economy has slowed to a level below its non-inflationary output capacity. Employment growth of 121,000 marks the third consecutive month job growth falls short of the normal level of labor force growth. It is particularly concerning considering that it often takes up to six months for the job market to respond to changes in the economy.

At Financial Watch we continue to believe it is time for the Federal Reserve to stop raising interest rates. Should Fed Chairman Ben Bernanke share our assessment that it is time to pause, the economy should be in decent shape. However, inflation remains elevated meaning the Fed could continue to push interest rates higher until the U.S. falls into a recession. The dot-com recession decimated stock prices. It was not too uncommon to hear of stories where multimillionaires found their families net worth wiped out by a faltering stock market. As the United States once again faces an uncertain outlook for our economy we believe it is prudent for investors to consider a worse case scenario.

Housing prices would bear the brunt of a recession. In the most severely overpriced housing markets it is realistic to project home prices by a third to half. Miami, Boston, and large parts of California are at most risk for a severe correction in home prices. Although Financial Watch believes a recession would be felt in housing markets across the nation. The stock market appears to be in much stronger position to survive a recession. In 2000 the average price to earnings (p/e) ratio approached 30 for the S&P 500 during the peak of the bubble. Presently the average p/e ratio around 15. Any investor keeping a keen eye on their investments over the past two plus years has to be puzzled why earnings continue to surpass market expectations, but their stocks remain stagnant. Although it may sound counterintuitive investors still focus on the damage that occurred during the dot-com collapse. As long as Ben Bernanke continues to push interest rates higher stocks will at best tread water, but if the Fed gets it right we will see a powerful rally.

It is extremely difficult, if not impossible, to predict where stocks could go if the Fed gets it wrong and we fall into a recession. First of all, we remain bullish in the long run on the stock market and stand by our prediction the Dow will surpass 20,000 this decade. It is going to be a tough summer, but it is prudent for investors to ride out the storm with high quality stocks. Speculative stocks have already been killed and this is not the time to go bargain hunting for more aggressive plays. However the bottom line is that if the Fed gets it wrong the pain will be much less this time around than the dot-com collapse. Financial Watch believes 9,000 is the floor for the Dow should the United States fall into a recession. Some of our models even suggest the markets have already fully priced in a recession. We doubt this is the case and believe on average the indices only stand to lose about 10-15% in the worse case scenario and unlike last time the damage would be spread out fairly evenly across the various market indices.