A Repeat of 1990?

S&P: It's too soon to tell if the economy and stock market will behave in the same way

by Sam Stovall From Standard & Poor's Equity Research

As a result of the equity market's response to the weaker-than-expected ISM report on February 5, investors now probably think the acronym stands for I'm Shorting the Market. (It actually stands for the Institute for Supply Management.)

Not only did it come in eight percentage points below expectations, but it also signaled a contraction in the U.S. economy. While we think the market had already factored in a mild economic recession, the ISM report has now made investors begin to consider a more severe scenario.

Prior to the report, the S&P 500 had undergone a counter-trend rally of almost 10% after a 16% correction (based on the October 9, 2007 high to the January 22, 2008 closing low) and a near 19% sell-off (based on the January 23, 2008 intra-day low). Aggressive interest rate cuts by the Federal Reserve, the likelihood of cuts worth 50 basis points at a minimum over the coming two Federal Open Market Committee meetings, the possibility of a swift passage of the economic stimulus package, and the frequent economic and stock market comparisons with the 1990 to 1991 period stoked the rally, in our view.

Indeed, David Wyss, Standard & Poor's chief economist, believes this housing and credit crunch-induced economic contraction is similar to the savings & loan (S&L) and junk bond-influenced economic recession of the early 1990s.

History never repeats itself, but it frequently rhymes. Whether Mark Twain really said it or not, it has a certain ring to it since we, along with a million other investors, are trying to decide if the October to January sell-off is mapping out a similar decline pattern made in the 1990 to 1991 bear market decline of 19.9%.

SO WHAT ARE THE SIMILARITIES?

Crisis Costs: On December 10, 2007, the Wall Street Journal reported the S&L Crisis of 1986 to 1995 resulted in $189 billion in writedowns, or 3.2% of gross domestic product (GDP), and estimated that the worst-case scenario for subprime mortgage losses would likely total $400 billion, or 3.0% of GDP.

Timing of Tops: The S&P 500 topped out at an average of more than nine months before the start of the 11 recessions since 1945. In 1990, the S&P 500 and economy both peaked in July 1990. This time, the 500 crossed the 1565 level on October 9, 2007, and we think a recession will be back-dated to December 2007, indicating the equity market anticipated this recession by less than two months.

Magnitude of Price Declines: In 1990, the S&P declined 19.9% in three months. Most recently, it fell 18.8% in about 3.4 months.

Possible Retest and Recovery: If the recovery ended on February 1, for this similarity to be carried forward, the late January lows of 1270 to 1310 are likely to be retested.

So, is it time to celebrate? It's too soon to tell, we think. Mark Arbeter, S&P's chief technical strategist, thinks we need to successfully test the 1270 to 1310 levels before he believes a bottom has been established.

In other words, the S&P 500 has to close in this range, accompanied by an increase in bearish investor sentiment readings. He looks to sentiment as a contrary indicator. A close above the 1395 recovery high on strong volume would have to be reached before he would deem the intermediate decline to have run its course.

From a fundamental perspective, we believe the greatest risk is not in missing a short-term, counter-trend rally, but in becoming too aggressive, too soon in the face of falling 2008 earnings estimates, decelerating U.S. and global GDP growth, and a possible second half strengthening in the U.S. dollar. We believe it prudent to maintain an underweight to U.S. equities and a marketweight to foreign stocks. We are encouraging an above-average exposure to cash until we think this correction has reversed course.

We also currently recommend a defensive sector posture, favoring the S&P 500 consumer staples, health care, and utilities sectors, and encourage a reduced exposure to the more cyclical, and economically vulnerable, consumer discretionary, financials, industrials, and information technology sectors.

Stovall is chief investment strategist for Standard & Poor's Equity Research Services .