Stovall: Making Sense of the Meltdown

S&P's chief investment strategist cautions against stepping in to the battered financial sector amid the current market turmoil

By Sam Stovall From Standard & Poor's Equity Research

Now that Lehman Brothers (LEH) has announced its intention to file for bankruptcy, and Merrill Lynch (MER) has agreed to be acquired by Bank of America (BAC) for $50 billion, they join Bear Stearns, Countrywide, Fannie Mae (FNM) and Freddie Mac (FRE), and IndyMac as fallout casualties from the credit and housing crises. What's more, with American International Group (AIG) attempting to resolve its own challenge of monumental proportions, we can at least say we've gone through the first half of the alphabet. The second half is next.

How will it likely play out? Based on the recommendations by S&P equity analysts to sell National City (NCC), Wachovia (WB), and Zions Bancorp (ZION), investors in these shares probably shouldn't wait around to find out.

But what about investors in the overall sector? Year-to-date through Sept. 12, the entire group has taken it on the chin, falling nearly 28%, or almost twice the decline of the Standard & Poor's 500-stock index. What's more, 14 of the 20 subindustry indexes are in the red for the year, with 10 of these slumping more than the market. Two sectors—Multi-line Insurers and Thrifts & Mortgage Finance—have led the way with declines in excess of 60%.

If History Is Any Guide

Does this mean we are only halfway through this carnage? From the Oct. 9, 2007, peak in the S&P 500 of 1565 to today's indicated open of 1215, amazingly, the S&P 500 has suffered only a 22% slide. This "baby bear" market compares quite favorably with the average 27% sell-off for all "garden variety" bear markets (declines of 20% to 40%) since World War II. Including the two "mega-meltdowns" (40%+ declines) of 1973-74 and 2000-02, the average decline has been closer to 32%. In other words, for the S&P 500 to approach "average" bear market levels, we need to experience another 5-to-10 percentage-point sell-off in prices.

The answer to the earlier question is that we probably are more than halfway through this overall bear market. Unless, of course we slip into another mega-meltdown. History says we won't, as these 40%+ declines are typically separated by 30 years—the one prior to 1973-74 occurred in the early 1940s. But history guarantees nothing, so I can only play the odds. As a result, I wouldn't try to be a hero and start a major buying campaign.

From a sector standpoint, unfortunately, it's unclear as to whether we are more than halfway to the bottom of this Financials free fall. In the last seven bear markets, including this one, while the S&P 500 fell an average 33%, the S&P Financials group declined an average 28%. These averages are fairly encouraging. However, in the 1990 bear market—which I think more closely resembles the cause of this bear, due to the savings and loan crisis and the junk bond meltdown—the S&P 500 Financials sector slumped 36%, vs. the S&P 500 index's decline of just 20%. With the S&P 500 Financials sector index already off 28%, we would need to experience another stock market decline on the order of 1973-74 to say we are only about halfway there. That comparison, while not currently projected, isn't out of the question.