Today, equity markets continued to show signs that at least a mild correction is underway as the S&P 500 Index closed at its lowest level since May 1st. After reaching an intra-day high of 956 on June 11, the S&P 500 has declined nearly 8% through the close of today’s trading at 881. From a technical perspective, the S&P closed below its downward sloping 200-day moving average of 885, a potential warning of more downside to come. In addition, commodities have begun to roll over as the reflation trade has lost momentum.

I see two major factors driving the recent declines. First, the “green shoots” crowd is losing more and more supporters due to the ugly June employment report released last Thursday. In a significant disappointment to those expecting a V-shaped economic recovery, 467,000 jobs were lost in June compared to an expectation of -350,000 jobs, and the unemployment rate ticked up to 9.5%. The economy has lost 6.5 million jobs since the recession began, and employment is now back to August 2004 levels. Over the weekend, Vice President Biden even admitted that the recession and resulting job losses were worse than the Administration expected, sparking some calls for a new economic stimulus package.

Those that have seen “green shoots” of less bad economic data have strongly argued that employment is a lagging indicator. It is true that traditional recessions – those sparked by the manufacturing sector or inventory corrections – often end months before the employment figures turn positive. However, in recessions caused by a financial crisis, job losses add to the vicious cycle of home price depreciation and loan defaults. In such a recession, employment is likely to become a coincident or leading indicator. For more detail on this concept click on this article in the Financial Times.

The second major factor driving recent declines is concern over the upcoming second quarter earnings reporting season. For the strong rally off the March lows to continue, investors will likely require fundamental improvement in corporate earnings. As the green shoots whither, suggesting a weaker than expected second half recovery, earnings improvement will be muted. While we expect many companies will meet or exceed pessimistic earnings estimates for the second quarter, the future guidance provided by these companies should drive market action over the coming weeks. With the major equity market indices sitting near important support levels, the earnings reports over the next couple of weeks should determine whether the rally regains its footing, or a deeper correction ensues.

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