A barrage of bad U.S. economic news stoked recession fears in August, causing investors and traders to turn decidedly defensive. The S&P 500 dropped 4.5% last month, with defensive sectors such as healthcare and utilities dramatically outperforming cyclical areas. U.S. small-caps fell 7.5%, consistent with the risk-aversion theme. Foreign stocks fared better; the MSCI World Ex-U.S. Index declined 2.7%, thanks to relative strength in emerging markets, which have been showing signs of “decoupling” from the morass of the developed world.

Investors continue to seek refuge in Treasury bonds and gold, which have been the favored asset classes since stocks peaked in April (Exhibit 1).

The principal source of economic stress in the U.S. continues to be joblessness. There are 15 million people searching for work, and the private sector employment ratio is at a 25-year low (Exhibit 2). The U.S. employment report for August due to be released this Friday will be particularly interesting for the markets.

Apart from the grim employment picture, housing remains a drag on the economy and on confidence. Despite the lowest mortgage rates in decades (the 30-year conforming fixed mortgage rate recently fell to 4.36%), home sales plunged to new lows in July, raising the risk that home prices could come under renewed pressure later this year and early 2011 (Exhibit 3). Economic uncertainty and the ongoing effort by households to repair balance sheets is keeping potential home buyers on the sidelines. A glut of unsold homes, rising foreclosures, unemployment and stringent access to credit all mean weak home sales will linger.

A staggering 14% of mortgages are in foreclosure or delinquent, and there will be an estimated 1 million foreclosed homes this year. In this context, the weakness in housing is not surprising. In addition, the government’s efforts to boost home sales with tax credits in the second half of 2009 and early 2010 provided a short-term boost, but took away future sales that would otherwise be occurring now.

The steady flow of negative economic news and the weak stock market have pushed investor pessimism into extreme territory. The latest survey from the American Association of Individual Investors (AAII) showed that only 21% of respondents were bullish. This is the lowest bullish percentage since March 2009, when stocks reached their bear market depths. Moreover, in late August, U.S. equity mutual funds and ETFs suffered $9.1 billion of redemptions ­one of the worst one—week outflows of the past decade.

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