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Soft Patch Hits Stock Market, But Not a Sign of an Impending Second Recession

If you're a US Treasury bond market watcher, you know that the drop in yields suggests a slowdown in economic growth. If you're a stock-market watcher, you know the same thing. Bonds started telling the weak growth story sooner than stocks, but that's often the case. The question remains whether it's another soft patch, like last summer, or something deeper and more sinister.

For everything that could go wrong, there remain things that could go right. Before the latest shocks to the system, business confidence had been riding relatively high on improving credit conditions.

Supply-chain recovery in Japan, the world's third-largest economy, is occurring quite a bit more quickly than many anticipated. For those who believe Japan's disruptions are just an "excuse" for weak growth, note that last week's Federal Reserve Beige Book mentioned Japan's supply disruptions 25 times!

As an example, according to ISI Group, US vehicle production in July is scheduled to surge nearly 24% month over month. Given that the auto industry now contributes more to US GDP than residential investment (housing), this coming surge could alleviate some of the double-dip recession concerns.

On energy prices, although there was no agreement on "official" output by the Organization of the Petroleum Exporting Countries, Saudi Arabia is likely to increase production, which could put downward pressure on oil (and gasoline) prices.

On top of that, if the Strategic Petroleum Reserve is tapped, that would likely also keep prices in check; not to mention the potential powerful impact if Muammar Gaddafi steps down from power in Libya, as has been rumored.

And it's not only in the United States that growth is slowing. Although I listed a hard landing in China as a risk, we could also see an end to China's monetary tightening if growth slows. On that note, tightening by the European Central Bank might come to at least a short-term end, as well, if inflation risks ebb and growth remains under pressure.

Reason for hope on the economic front … how about the stock market?

The S&P 500 has been down for six consecutive weeks, as has been well reported in the media. The correction so far has taken 6.8% out of the S&P 500 since its late-April high. The S&P 500 has had declines for six consecutive weeks an ironic six other times since 1995. The average decline over those periods was -11.2%.

As calculated by Ed Yardeni, president and chief investment strategist of Yardeni Research, Inc., big gains did occur in the past during the six weeks from the bottoms of those periods, though the S&P 500 did not make new highs during any of them. The S&P was up an average of 5.8% from the bottoms, and rose four out of five times in the past.

Weak market action certainly worked its "magic" on investor sentiment, typically a contrarian indicator of market performance.

Not out of the woods

We're likely not out of the woods, either for the economy or the stock market. Last summer's correction was about 15%, and although we may escape that severe a correction, to see something more than the 7% we've seen since the late-April highs would not be surprising.

It is one of the reasons why our sector recommendations have only two outperform ratings (technology and health care) and two underperform ratings (consumer discretionary and materials). For those of you with a more tactical orientation, it suggests a continued need to keep some powder dry.

But longer term, our optimism is not meaningfully dented. More than half of the S&P 500's stocks are now oversold and setting up for bounces, at least. Stocks are trading at a low 13 multiple on 2011's expected earnings, which do not appear to be pie-in-the-sky.

Finally, the path toward monetary policy normalization has been pushed out and rates should remain accommodative well into 2012.

Important Disclosure
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Content provided by Charles Schwab, Hong Kong
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