A Terrible Third Quarter Will Be Followed by a Bad Fourth

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

The third quarter of 2011 had the biggest drop and most volatility for stocks since 2008.  The fourth quarter may not be much better since the cause of the problem is a new credit crisis and an emerging global recession. Both will continue to be a drag on the market.

Except for small cap stocks, the U.S. markets did somewhat better than many overseas markets during the quarter. The Hang Seng in Hong Kong was down 25.7%, the CAC-40 in France fell 25.6% and the DAX in Germany dropped 25.0%. Only the Russell 2000 in the U.S. was lower by a comparable amount, falling 24.1% from its May 31st close. These indices are all in deep bear territory. Not much better was the Bovespa in Brazil. It lost 19.0% in the third quarter. The Brazilian market peaked in November 2010 and it too is in a bear market.

While the bigger cap U.S. indices weren't down as much, they were severely damaged nevertheless. The S&P 500 was lower by 15.9%, the Nasdaq by 14.8% and the Dow industrials by 13.2%. This was just the drop during the quarter. U.S. stocks in general peaked on May 2nd. From its high back then to its low in the third quarter, the S&P 500 dropped 19.6%. A bear market is defined as a loss of 20%.

Volatility returned to the markets with a vengeance in the third quarter. The VIX index reached a high of 48.00, not much below its peak in the 2000 to 2002 mega-bear, but well off its Credit Crisis peak around 90. Mini-crashes returned to the market, with both the Nasdaq and Russell 2000 experiencing drops equal to or greater than 5% on three different days.  There were four consecutive days in August when the Dow was up or down by 400 points or more. A volatile market is prone to selling and  markets usually need to calm down before they can bottom.

Just as was the case during the Credit Crisis year of 2008, only two major assets were up in the third quarter — treasuries and gold. The 10-year hit an all-time low yield of 1.71% (bond prices go up when yields fall). This was well below the previous low that took place because of the Great Depression in the 1930s. While the price of gold fell by 15% at the end of the quarter, it rallied from the beginning until its peak on September 6th. It wound up rising 5.8% (as measured by GLD) from its closing price on May 31st. Its companion precious metal, silver, had a quarterly drop of 23.1%.

There is no reason to think that the market will bottom until problems in Europe come to some stable resolution. Greece admitted over the weekend that it would not be meeting the budget targets that were part of the terms of the first bailout. Global markets are once again selling off, as if this was somehow surprising news — Greece has misrepresented its financial number repeatedly, it would only be surprising if they turned out to be accurate. Greece may still get its next tranche of bailout money, since the EU has shown over and over again that its standards for the currency union are meaningless. Eventually though Greece will default because too much bailout money will be needed to keep it afloat. Even at that point, Spain and Italy will have to be reckoned with.

The other issue facing the markets is a global economic downturn. While a case can be made that the post-Credit Crisis economy never got out of recession (the unemployment rate and consumer confidence remained at recession levels for instance), the important question is whether or not economic activity is declining now. Last week, even the ECRI (Economic Cycle Research Institute) admitted the U.S. economy was heading down. Since a credit crisis can make an economic decline much worse, this doesn't bode well for the markets in the upcoming months.
Disclosure: None 

Daryl Montgomery
Author: "Inflation Investing - A Guide for the 2010s"
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.