The Institute for Supply Management's December index of manufacturing activity plunged to its lowest level since the recession of 1982, and as this chart shows, the index is consistent with GDP growth in the fourth quarter of last year of -6%, which would also be the worst since 1982. With numbers this bad—and technically worse than expected—why is the stock market up today, extending gains that began last November 21st?
There are several possible explanations. The one advanced by the press today is that investors are encouraged by all the talk of an aggressive Obama stimulus plan, since it would all but guarantee an economic recovery.
In my view, the bigger Obama's stimulus plan, the worse it is for the economy. But I think the market has already priced in an egregious spending plan. The expectation of a massive expansion of government and attendant tax increases was one of the principal reasons that the market has been so depressed in recent months; so depressed in fact that prices fell to levels that were consistent with an economy that was worse than the worst of the Great Depression. By this logic, today's disastrous ISM number fell short of the market's true expectations.
Another reason the market is up is that the economy may have passed an inflection point; that it is decelerating but at a slower and slower pace. The financial markets have shown impressive signs of healing in recent weeks—lower swap and credit spreads, declining volatility, slowly rising T-bill yields—and commodity markets are now showing signs of bottoming at levels that are still significantly higher than the all-time lows of late 2001. This crisis began with a severe dislocation in the financial and housing markets, and we have now seen substantial repricing activity, a return of liquidity, and much lower financing costs; it is not unreasonable at all to say that the financial and housing storm is passing.
This crisis impacted the broader economy first through a massive decline in housing construction which began three years ago, then by way of a near-collapse of the banking industry earlier this year, and finally through a panic-induced decline in demand in the past few months. Remove the underlying cause of the problem—fear of losses—and you find that the vast majority of the economy remains intact. Economic life does indeed go on all across the country, even as many companies and many displaced workers struggle.