Why the market is melting down

By Jon Markman

Nine hundred points in little more than a month. That’s the unfortunate story for the Dow Jones industrials, as a stock market that was this close to hitting record levels in early May has suddenly crumbled, falling 8%.

And that’s just the Dow's ($INDU) decline as of Tuesday's close. Tech stocks, as measured by the Nasdaq Composite ($COMPX), are down more than 10.3%. Small-company stocks are down more than 13%.

And, though the market was rallying Wednesday, it could get worse. As I suggested early last month – in this column and this journal entry -- I think there is real potential for another 10% to 20% decline over the next five months. As much as I wish that weren't the case, it seems unavoidable.

There is no shortage of culprits. The best way to think about it, though, is that all over-the-top advances in markets lead to over-the-top declines. It happened with tech stocks in 2000, and now it’s happening with real estate, international stock markets and commodities.

It’s a natural spin of the economic cycle. When people are willing to pay a lot for something that is scarce, producers make more of it. Ultimately, they produce so much of it that it loses scarcity value and, instead of a shortage, there is a glut. When smart investors detect that this has happened, or is about to happen, they flee -- and then prices collapse. It could be tulips. It could be Internet stocks. It could be new homes. It could be copper and gold.

Housing woes

At present, the key underpinning of market success that has been kicked away is residential construction. Companies that built and helped build houses, sold and helped sell houses, and loaned money to all concerned, were on an epic roll last year. But now that outstanding, five-star movie is playing in reverse. Housing starts have been falling all year and were down to 1.85 million in April.

Amid slack demand, home prices are already declining or flat everywhere, with Midwest and South regional declines the worst. A collapse in home prices works its way deep into the economy. For one thing, declining sales tend to forecast declining consumer spending, with a lag of about nine months, according to ISI Group analysts. The data suggest consumer spending is on track to decline by 1.6% year-over-year. This is important because housing and consumer spending combine for 75% of total U.S. economic output.

Home construction has also been a huge part -- about 20% -- of employment growth over the past two years. If the housing decline numbers continue on their current path, overall employment numbers will continue to drop, as they did last month.

When people work and earn less, they buy less. If that sounds bad, you’re right. In the past couple of years, people have made up for the shortfall by taking money out of their home values via a process that economists call “mortgage equity withdrawals.” (You might know it better as a home equity line of credit.) But that phenomenon is reversing now as well.

So how does this fit into the stock picture? Keep in mind that stocks lead the economy, not the other way around. In other words, while it’s tempting to say that if the economy is weak then stocks should be weak, it doesn’t work that way. The weak stock market last year and so far this year has helped forecast a softening economy in the second half of this year.

If the market continues to stumble over the next five months, as I expect, then it will foretell at least a serious pause in economic growth on the six month horizon, though probably not an outright recession. My economic and investment models continue to forecast the potential for one last hurrah in stock prices this month before a precipitous decline in July through October. That’s potential, not a guarantee. But it’s enough of a potential to worry about.

This sort of move is well-documented in market history as a bearish phase should be expected every 52 months, or roughly four years. Bear markets occur with great consistency. Just looking at the postwar period, we had bear markets in 1949, 1953, 1962, 1966, 1970, 1974, 1978, 1982, 1987, 1990, 1994, 1998 and 2002. This is sort of like one of those easy math tests that schools give fifth-graders. What is the next likely number in this series?

No climbing this wall of worry

In many ways, it seems to me that the lessons that we learned in the 2000-to-2002 bear market have worn off. And, I think that right now is a good time to remember that while most of us like to think of ourselves as optimists and long-term investors, there come times when our enthusiasm becomes a little bit disconnected from reality.

There is a point when the concept of long-term investing must give way to pragmatic investing. And I think that time is right now.

I think it is usually very important not to get too weighed down with what can go wrong in the market. If you're a smart person, you have a critical mind and can nitpick all kinds of problems with the world. You can see that the dollar is falling, energy prices are soaring, home prices are stalling, the U.S. budget deficit is out of control, the administration and Congress are flailing and inflation is on the advance. And you can conclude from all of these concerns that the market should fail.

As investors, we don't really care about all of these facts except as they pertain to individuals' appetite to buy stocks. All of these terrible things can occur, and yet investors can remain buoyant and drive the market higher. It's called "climbing the wall of worry," and it is a very important part of a strong bull market.

But there are times when a lot of stuff can be going wrong in the world, and the market does not climb the wall of worry. Sometimes, investors do get into a dark mood and sell into bad news.

More room to fall

The average decline of the 14 bear markets since 1949 was 26.5%, ranging from 50.5% in 2002 to 8.3% in 1998. Right now, we're off about 5% from the early-May peak, so even if you pick the midpoint between the best at -8% and the average of -26%, it could be a pretty ugly result.

While it makes sense to be a "long-term" investor when stocks are generally rising, you can lose a lot of your capital -- and emotional stability -- if you try to be a long-term investor while values are generally falling.

Back in May buying power was drying up, the mood was turning and it was time to bundle up for the market equivalent of winter. Now winter is in full force, and it’s still not a good time to go outside.

Jon D. Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Markman did not own or control shares of companies mentioned in this column.