Let's put this market into perspective. Generally bear markets go through three psychological phases - "denial", "concern", and then "fear & capitulation". Most often, but not always, the market rallies between each phase. The denial phase is the initial significant downleg from the bull market high. During this phase the majority of investors are still in a bullish frame of mind, after seeing continuing profits in their account and having seen the market bounce back from prior corrections. They look upon the decline as merely another buying opportunity and think that stocks are now cheap. In addition the fundamentals during this phase are still perceived as positive and any negative news is downplayed. Following this phase the market usually rallies, but on weak breadth and lower volume.
Eventually the market tops out well below its previous high and starts a new downleg carrying it to lower lows. During this phase the fundamental news significantly worsens and investors realize that that a bear market is in force. This is the phase of concern. During this phase many investors sell, but others hang in, feeling that the bad news is discounted and that a bottom is near. At this point the market may rally again as many observers feel that the decline has ended and that a new bull market has begun. This rally, also characterized by weak breadth and low volume, subsequently fails and heads down. At this point the majority becomes exceedingly bearish and throws in the towel, fearful of further declines and the potential disappearance of their assets. This is the capitulation phase, when stocks are sold on fear and emotion rather than on rational analysis. It is at that point that the market is finally ready to make an important bottom.
Obviously the above description is a generalized outline based on history, and never takes place in exactly the same way. However, we think that it provides a rough framework of what to expect.
Currently, we believe the market is now leaving the denial stage and is entering into the concern stage. We think that we are either in a recession now or about to enter one very soon. Consumers are likely to remain under pressure as a result of the declining home prices, plunging mortgage equity withdrawals, the ongoing deteriorating credit situation, a weakening labor market, a negligible savings rate, and high gasoline and food prices. With consumer spending accounting for 70% of GDP, it seems that a recession is a high probability-and capital expenditures usually follow consumer spending by a quarter or two.
As we have emphasized in many of these comments, there will be no end to the financial stress until housing prices stop declining. And housing prices will not stabilize until the record inventory of unsold homes is worked off-- and that will take several years. The housing weakness is currently spreading to commercial real estate and other sectors of the economy (e.g. credit cards and automobiles).
Meanwhile, with all of this weakness in the economy, the Fed is still locked in a box. The headline CPI is rising so fast that the Fed cannot continue lowering rates, and if they attempt to raise rates in order to control rising prices or defend the dollar they could drive the economy into a more severe recession or even a depression.
With all of these "headwinds" (and others described in recent comments), we believe the denial stage in the market occurred from October at S&P 500 1576 to March 17th at 1257. The relief rally discussed above between the stages reached 1440 in May, and the current decline we believe is changing over to the "concern" stage. The concern stage that we believe is becoming more widespread among investors will be almost unanimous if and when we break through the Bear Stearns climatic low of 1257. It is possible to go from the concern stage to the fear & capitulation stage if the decline below 1257 is dramatic enough, but we suspect the downtrend will be interspersed with misleading rallies. However, at some point investors will capitulate and the market will bottom. At present we believe the bear market has much further to go on the downside.
