A Pivotal Week for Stocks

Data and earnings releases -- and the Fed meeting -- may offer a clearer view of the market landscape. Investors may not like what they see

by Sam Stovall From Standard & Poor's Equity Research

This week, investors will have a host of information to contend with: A continuation of fourth-quarter earnings releases, the Federal Reserve's two-day policy meeting, influential economic data that will be released during the Fed meeting. Investors will also be able to tally market results for January as the month wraps up, a typically accurate barometer month for the year ahead.

By the end of the week, we think investors will have a clearer view of the near-term outlook for equities, and they probably won't like what they see. While S&P’s Investment Policy Committee is looking for the S&P 500 to end the year at 1560, up 6% on a year-over-year basis, we believe the next few weeks and months will continue to be challenging for investors as they gauge the severity of the recession we see as increasingly likely for the U.S.

Earnings Releases

This week, earnings from such well-known names as Allstate (ALL), Eli Lilly (LLY), EMC (EMC), McDonalds (MCD), and Verizon Communications (VZ) will offer additional data on 2007 results and 2008 outlooks. Thus far into the fourth quarter 2007 reporting season, S&P equity analysts predict the S&P 500 will experience a more than 21% year-over-year earnings decline for the quarter and a 3.5% shortfall for the full year. Not only are these current forecasts substantially lower than our estimates at the beginning of 2007 (when we saw a 16.6% increase for the fourth quarter and a 9.6% gain for the full year), but they are also below our estimates from the end of last month.

I don’t think our analysts’ forecasting acumen is the question, as their STARS track record since 1987 certainly proves that, in my opinion, but rather I believe it continues to show the lack of near- and longer-term clarity and guidance, as a result of the ongoing credit crisis and housing decline, and the uncertainty surrounding ongoing writedowns. In just 22 days, S&P equity analysts have reduced their fourth quarter and full-year 2007 operating EPS for five of 10 sectors in the S&P 500, with the outlook for the S&P 500 Financials sector being the most variable.

Estimates for 2008 operating results on an absolute level have also experienced across-the-board reductions. Eight of the 10 sectors in the S&P 500 have already seen decreases in estimates from 0.1% to nearly 5.5% since November, with the S&P 500 itself experiencing a downward revision of nearly 2%. Yet interestingly, the year-over-year percent change in full-year results has actually risen over the past few months, as the 2007 projections have fallen more rapidly than the 2008 forecasts, thus creating a more-favorable basing effect for the year-ahead’s numbers.

The Meeting of the Minds

This week marks the Fed’s first FOMC meeting of the year. Having already cut the Fed funds rate to 3.50% from 5.25%, the question is whether the Fed will lower rates again only a week after cutting by 75 bps in an emergency move. David Wyss, Ph.D., S&P’s Chief Economist, believes that if the Durable Goods and GDP data look good, the Fed may decide to leave rates alone until the March meeting. At this time, S&P expects a rate cut, however, followed by another cut in March. We see the Fed funds rate at 2.5% by mid-year.

Should the Fed opt to do nothing, S&P’s Equity Strategy Group believes that equity investors will be disappointed. We envision traders shaking their collective heads and mumbling that the Fed remains behind the curve as they hit “send” to issue electronic sell orders.

A Month of Mayhem

The end of January is fast approaching. Year to date, through January 25, the S&P 500 declined 9.4%, while the S&P MidCap 400 and SmallCap 600 indexes fell 10.1% and 8.9%, respectively. Since the peak on October 9, 2007, the S&P 500 has weathered a correction of 15.0%, while mid-cap stocks lost 15.8% and small caps fell 18.5%.

Within the S&P 500, the Financials and Telecommunications sectors are in bear-market mode having declined more than 20% each. Consumer Discretionary issues are down nearly 19%, while the Consumer Staples sector has held up best, falling just 4.3%.

Below the surface, one can see that the carnage is widespread, as only 11 of the 130 sub-industries rose during this nearly three-month decline. Six groups posted double digit advances (Agricultural Products, Coal & Consumable Fuels, Education Services, Fertilizers & Agricultural Chemicals, Gold and Health Care Facilities), while 119 sub-industries (92% of the total) declined; 97 of them (75%) posted double-digit losses and 38 (or nearly 30%) are now in bear market mode after erasing more than 20% of their values.

Not a good start to the year. In fact, should the 9.4% decline hold for the full month, it would be the worst performance since 1928 (which is as far back as I have monthly data). January 1970 saw the second worst performance with a drop of 7.6%. It would also be the 23rd time the “500” has declined in this second-best performing month of the year, which, since 1945, has seen the S&P 500 advance an average 1.4% and post increases 65% of the time. Indeed of the 22 times the S&P 500 has declined in January in the past 62 years, the full year was off 13 times (60% of the time) averaging a decline of 4.3%. Of course, history is only a guide; it’s never gospel.

For the near term, S&P Equity Strategy remains committed to our defensive allocation and sector approach. While we believe there remains the possibility for the equity markets to experience a counter-trend rally in the near term, we see economic and technical headwinds eventually forcing equity indexes to retest recent lows before either signaling the all-clear or continuing their descent.

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