Fed comments on 5-6 year US recovery send stocks down

It was hardly surprising that the comments in the Beige Book by the Fed that the US recovery may take five to six years contributed to a 2.9 per cent fall in the S&P 500 by the close on Friday.

There was also news that US price levels have fallen for three months in a row for the first time since the 1930s. Deflation is back. This is the stuff of a depression not a recovery.

Financials disappoint

Even the much trumpeted second quarter financial results have disappointed investors. The euro zone crisis is having a predictable knock on impact with a strong dollar hitting export profits and the crisis upsetting earnings for financial firms again.

But investors with an eye for a time period longer than a week or two ought to be paying more attention to the warning from the Fed. You can see this in a positive light as a confirmation that interest rates will stay low or fret about what it means for business activity in the USA.

Manufacturing activity and confidence reports confirm that the recovery is not coming through. Indeed now that the stimulus package is fading the recovery is also fizzling out.

The stock market upturn since March 2009 was something of a self-fulfilling recovery as higher and higher share prices helped to bolster confidence and keep spending levels higher than otherwise. Withdrawing this private sector stimulus package from the economy will compound to the downside.

Market timing

But it is hard to know how long investors will take to respond to the increasing realization that stocks are heading lower and that the long rally will now be followed by an inevitable correction. The rush to the door could come on Monday or take until October to break.

Bulls have to come up with a counter argument. What could possibly push the market higher? Good news now seems always related to the fading stimulus package. Bad news is the new reality, and the spin doctors are running out of ammunition.

Even Chinese economic growth is slowing down as the biggest stimulus package in history also begins to unwind amid an overheating economy. After all, how many new cars can a nation buy before its roads are clogged, and a wage-price spiral eats into thin corporate profit margins?

It all points to another big shake-out in asset prices. The rally was longer and stronger than expected. The double dip will be longer and deeper than expected. The higher you go the harder you fall.