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Has the market overpriced the probability of a US recession?

January 21st, 2008 Michael McDonough
Global equity markets have clearly priced in a US recession. We expect, & the futures market is currently indicating, that the US markets will open tomorrow down around 4%, after the MLK holiday…
Has the market overpriced the probability of a US recession? We believe so.
Looking back at the last recession in 2001 we saw the SP500, Hang Seng, & FTSE drop 31%, 62%, & 28%, respectively from their 2000 close to September 2001. Currently, given an estimated 4% loss tomorrow in the S&P we expect to see ytd losses of -14%, -21%, and -14% for the same indices. A very similar pattern to 2001. Keep in mind, we do not believe, even given a recession, we would see the same magnitude of losses as we did in 2001, given the inflated company valuations at the time.
Here at Fiat Economics, we still believe the probability of a US recession remains below 50%, but is rising. However, the magnitude of this most recent sell-off indicates to us that global EQ markets have nearly fully priced in a US recession. (As an aside I don’t anticipate we will be hearing much from those decoupling proponents) Once the markets ’stabilize’ from this drop we should return to very volatile news related market movements. However, we have a relatively quiet week on the economic front , so the market will look towards earnings for guidance. We expect the market will be bolstered by our anticipated 50bp cut at the next FOMC meeting on Jan. 30th, which in our view should reduce the probability of a recession. The bottom line is, if you believe, like us, the probability of a US recession is still below 50%, this week will provide you with some great buying opportunities both in the US and abroad.
**If US markets were to experience a dramatic loss tomorrow in the double digit zone, it is possible we could hear from the Fed before the Jan. 30th meeting.
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