The Untold Story Behind Recent Market Correction
by David Yu
But it wasn't the dismal employment report nor the credit problem that sent the stock market into a tailspin. Everything attributed to recent market decline, from depressing real estate market to diminishing consumer demand, had already been known for a long time. And the ubiquitous media coverage and exploitation of the stalling economy had perhaps already desensitized the fear of a recession. The only undetermined event that had really caught the market by surprise might've been the Iowa caucus results. On January 3, 2008, record number of Democratic caucus-goers, which outnumbered Republicans by 2-to-1 margin, decided Obama and Edwards as their No. 1 and No. 2 candidates. Both of them plan to end the war in Iraq and start withdrawing troops immediately. They also don't consider having any permanent military base in Iraq.
Political affiliation dictates argument over whether Bush administration's tax cut or war spending in Iraq helped fuel the U.S. economy in recent years. However, there's little doubt that the nonpartisan Congressional Budget Office's estimate of up to $9 billion per month war spending, on top of an initial outlay of up to $13 billion for the deployment of troops to the Persian Gulf region, had greatly enriched the supply side of the economy.
Military fueled growth. Polish economist, Michal Kalecki, who had first theorized military Keynesianism in 1943, argued that achieving full employment through public spending made capitalists and politicians nervous because it risked over-empowering the working class and the unions. The military was a much more desirable investment, although justifying such a diversion of public funds required a certain degree of political repression, best achieved through appeals to patriotism and fear-mongering about an enemy threat.
Prior to the U.S. invasion of Iraq, unemployment rate in the U.S. had surged all the way up to almost 6% in February 2003 (see Chart 1 below). The rate subsequently declined to below 4.5% as war spending in Iraqi grew to be more expensive than $430 billion cost for Korean War and $600 billion for Vietnam War. Ending this astronomical government spending and bringing the troops home at a time when the U.S. economy's experiencing multifaceted difficulties would almost guarantee a severe recession.
Chart 1
Every major war ended with economic contraction throughout history, according to NBER (National Bureau of Economic Research) business cycle statistics. Recessions in 1919, 1945, 1953, and 1973 immediately following the ends of WWI, WWII, Korean War, and Vietnam War, foreshadow recurrence of another recession at the end of Iraqi War. That might've been the shock to the system and the real story behind market pessimism.
In the short run, however, the market appeared to have overreacted to the preliminary election results. For one thing, from this volumist perspective, recent market decline had not been fully supported by trading volume. While current market correction from December 11, 2007 to January 9, 2008 was more severe than the corrections took place in August and November 2007, the trading volume appeared no where near the level reached in the previous two corrections (see dark volume bars on Chart 2 below). Incidentally, if the market's always right, why are there market corrections?
Chart 2
In addition, while the AAII and the Market Vane investors' sentiments had plunged to recent new lows, the percent of AAII's Neutral sentiment had risen to 7-week high and surpassed the bullish sentiment (see circle in Chart 3 below). This indicates rising number of investors having reservations about recent market selloff. 7 weeks ago, when the AAII Neutral sentiment surged above 21% while bullish sentiment dropped drastically from the previous week, the market rallied more than 8% immediately following that dramatic shift of sentiment.
Chart 3
For all the pragmatic reasons, how soon the war in Iraq ends really depends on how much the market trusts politicians and their promises. It may be a tad too naive and a bit too hasty to believe the end of Iraq War is a forgone conclusion. And, as soon as the market awakens to this reality, a counter rally should ensue. The fiercest market rallies occurred in bear market. Were that true this time as ever, then this counter rally may have quite a way to go.
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