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S&P's chief investment strategist on what the market is telling us now as investors brace for a big U.S. sell-off Tuesday
From Standard & Poor's Equity ResearchThis market has had a perfect record of ruining holidays and vacations, as the S&P 500 posted sharp declines during summer vacations in 2007, during the New Years-shortened week and on/following this year’s Martin Luther King holiday.
Today (Tuesday, Jan. 22), investors are girding for the second day of a global panic sell-off, in my opinion, which will now include the U.S. following its tension-filled day off, as a result of the increasing belief that the U.S. economy will slip into recession, combined with the unwinding of recent beliefs that global economies had decoupled and that a slowdown or recession in the U.S. would not materially impact foreign economies. In other words, many believed that what happens "over here" wouldn't affect what happens "over there."
So much for that emerging tenet.
Now that world equity markets are in freefall, when will it likely end, and could today actually become that often sought after "capitulation day" that technicians use to identify near-to-intermediate-term bottoms? Mark Arbeter, S&P's chief technical strategist, has been on the money with his calls over the past year, in my opinion. Earlier, he identified 1250 as a likely S&P 500 bottom for this decline, due to the convergence of trendlines, moving averages and retracement levels. Over the weekend, I asked him what he would have to see before he felt the need to set an even lower target.
"There is absolutely no way to tell where things will bottom out in these panics until after the fact," he said. "You just have to let them play out."
Arbeter points out that 10 largest one-day losses for the S&P 500 in descending order were: 20.5% on Oct. 19, 1987; 8.3% on Oct. 26, 1987; 6.9% on Oct. 27, 1997; 6.8% Aug. 31, 1998; 6.8% on Jan. 8, 1988; 6.7% on Sept. 3, 1946; 6.7% on May 28, 1962; 6.6% Sept. 26, 1955; 5.8% on Apr. 14, 2000; and 5.4% on June 26, 1950. Except for the decline in 2000, these drops were very close to major market lows in both time and price.
Arbeter concluded by saying "Should the S&P 500 close at least 1% below the 1250 level, however, and remain in place for two straight days, the next zone of chart support that I see is in the 1140 to 1170 range."
One bit of disconcerting historical fundamental data to us is the abnormally low average price-to-earnings ratio recorded by the S&P 500 at the end of market sell-offs in anticipation of recessions. Since 1945, the P/E on trailing 12-month "as reported," or GAAP, EPS averaged 12 times, about 30% below the 16.5 times trailing results of today, based on the S&P 500 trading at 1250 and GAAP earnings of $75.50 that includes our estimates for the fourth quarter of 2007.
More optimistically, however, the S&P 500, at the 1250 level, would be trading at 14.5 times trailing operating EPS, or a 25% discount from the average P/E of 19.4 times since 1988, when S&P started capturing operating EPS results.
On Jan. 9, S&P's Investment Policy Committee reduced its year-end target for the S&P 500 to 1560 from 1650, and embraced a defensive sector posture, in anticipation of additional market declines. On January 16, the IPC reduced its recommended allocation to international equities. Last week, articulating our decision, Alec Young, S&P's International Equity Strategist explained that "even though we continue to recommend U.S. investors maintain a long-term exposure to international equities, we believe that portfolio rebalancing is now appropriate in both our developed and emerging market equity weightings". While international equity markets have significantly outperformed the S&P 500 during the past several years, S&P thinks they have recently stumbled along with domestic markets as a result of the projected slowdown, and possible contraction, of the U.S. economy.
Also, notes Young, while the dollar still remains relatively weak, S&P thinks the dollar's multi-year decline against key foreign currencies will likely slow this year, as foreign central banks begin easing more aggressively to offset slowing growth in their economies. At the same time, S&P expects the mid-year end to the Fed's easing cycle will ultimately make the greenback more attractive.
Finally, David Wyss, S&P's Chief Economist, told me on Jan. 21 that a joint rate cut, or infusion of liquidity, by the U.S. Federal Reserve and the central banks of Europe and England would likely occur and offer support to the equity markets. At 8:20 am on Jan. 22, the Fed cut the Fed funds rate target by 75 basis points to 3.50% in an emergency move. Will that be enough to stem further losses? We still look for a decline in equity prices on Tuesday, and believe the markets will tell us when the worst is over, rather than the other way around.