Stocks: A Rising Wall of Worry

But S&P's strategists believe much of investors' worst fears has already been discounted in international equity valuations

by Sam Stovall, Mark Arbeter and Alec Young From Standard & Poor's Equity Research

Since celebrating the Federal Reserve's discount and fed funds rate cuts on Oct. 31, the S&P 500 has declined nearly 5% through Nov. 9 on what we believe to be a descending stair-step of worries.

Prior to the end of last month, equity markets appeared willing to look past the continued housing woes, financial writedowns and resignations, as well as earnings declines and elevated oil prices, since it was believed that the Fed's proactive approach would head recession off at the pass. Yet the accelerated decline in the value of the dollar, triggered by indications from Chinese officials that they would diversify more than $1.4 trillion of foreign exchange reserves away from the greenback (officials later backtracked on those comments), pushed oil prices above $98 per barrel and reignited investor concerns that further weakness in the dollar, combined with Chairman Bernanke's comments that inflation is as equally troubling as economic softness, may handcuff the Fed from being able to fight recession.

Add concerns that third-quarter S&P 500 operating earnings estimates would continue to dwindle as a result of earnings impairments from major financial institutions and discouraging comments by Cisco (CSCO) management that the tech giant sees a softening in the U.S. enterprise market, and you have a recipe for equity price declines.

S&P's chief technical strategist, Mark Arbeter, does not believe the share-price downturn is over just yet, despite the encouraging recovery in prices late Thursday, Nov. 8. He sees the S&P 500 eventually declining 8% to 12% from its high of 1562.47 on Oct. 10. In the meantime, he thinks we could see a few days of price recovery, since the S&P 500 in general, and the S&P 500 Financials and Consumer Discretionary sectors in particular, have experienced such sharp price declines in a short period of time. Case in point: Nearly half of the 130 industries in the S&P 500 are currently more than 10% below their weekly highs from earlier this year.

We think the inflation reports due out next Wednesday and Thursday will be litmus tests to the concern that inflation may tie the Fed's hands. Wall Street expects the producer price index to post a 6.0% year-over-year increase in October vs. a 4.4% advance in the prior month, while the core PPI, which excludes volatile food and energy prices, should move higher to 2.5% from the 2.0% seen in September. We believe the consumer price index will be less troubling, however, as it is seen rising 3.4% on a headline basis (vs. 2.8% last month), while the core rate is expected to rise 2.2% vs. 2.1% last month, above the Fed's unofficial comfort zone of 1.0%-2.0%.

S&P Economics acknowledges that near-term inflationary concerns will likely continue to catch investors' attention, but believes that oil prices will moderate from these inflated levels and average $84.67 per barrel. in 2008, thus contributing to the core CPI posting an increase of around 2.0% next year.

What's more, S&P's economic forecasters don't foresee a recession, even though they recently increased the odds of a downturn to 40% from 33%. They are still looking for the Fed to cut rates at least one more time by the January, 2008, FOMC meeting, and take additional measures, if needed, to forestall a possible recession.

S&P analysts project a more than 5% increase in operating earnings for the S&P 500 in 2007, and currently expect EPS growth at 14% for 2008. S&P's Investment Policy Committee sees the S&P 500 closing 2007 at the 1560 level, and recently established its year-end 2008 target at 1650. We recommend underweighting the Consumer Discretionary and Financials sectors, while overweighting the Information Technology sector, citing above-market EPS growth prospects, a large international exposure, and positive longer-term technicals.

Scott Kessler, S&P's Information Technology sector group head said on Nov. 8 that as a result of the sharp near-term sell-off in tech stocks, "I think investors have begun questioning the sector's defensiveness vis-a-vis the housing recession and credit crunch."