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Current market and economic conditions are reminding many investors of the start of the last decade. S&P takes a closer look
From Standard & Poor's Equity ResearchAs a result of the equity market's response to the weaker-than-expected ISM Non-Manufacturing report on Feb. 5—sending major indexes to big losses—investors now probably think those initials stand for "I'm Shorting the Market." Not only did the services index come in 8 percentage points below expectations, but it also signaled that the U.S. economy is currently in contraction. We believe that while the market had already factored in a mild economic recession, the ISM report has made investors begin to consider an even more severe contraction.
Prior to this worse-than-expected report, the Standard & Poor's 500-stock index had been experiencing a countertrend rally of almost 10% within a 16% correction (based on the Oct. 9, 2007, high to the Jan. 22, 2008, closing low) and a near 19% sell-off (based on the Jan. 23, 2008, intraday low). The market's partial comeback was aided, in our opinion, by the aggressive easing actions of the Federal Reserve, the likelihood of at least another 50 basis points of cuts over the coming two Federal Open Market Committee meetings, and the possibility of a swift passage of a government economic stimulus package.
Indeed, David Wyss, S&P's chief economist, believes this housing- and credit crunch-induced economic contraction is similar to the savings and loan- and junk bond-influenced economic recession of 1990-91. Wyss also believes the recession of 2007-08 will be similar in severity to the 1990-91 contraction.
"History doesn't repeat itself, but it rhymes." Whether Mark Twain really said that or not, it has a certain ring since we, along with a million other investors, are trying to decide whether the October to January sell-off is mapping out a similar decline pattern made in the 1990-91 bear market decline of 19.9% (which S&P deems a bear market, due to rounding).
So what are the similarities?
Crisis Costs: On Dec. 10, 2007, The Wall Street Journal reported that the S&L crisis of 1986-95 cost $189 billion in writedowns, or 3.2% of gross domestic product, and estimated that the worst-case scenario for subprime mortgage losses would likely total $400 billion, or 3% of GDP.
The Timing of Tops: The S&P 500 topped out 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 S&P 500 crossed the 1,565 level on Oct. 9, 2007, and we think a recession will be backdated to December, 2007, indicating that the equity market anticipated this recession by less than two months.
Magnitude of Price Declines: In 1990, the S&P declined 19.9% on a closing basis in three months. This time, it fell 18.8% (using the intraday low of 1,270 set on Jan. 23, 2008) in about 3.33 months.
Possible Retest and Recovery: If the recovery ended on Feb. 1, for this similarity to be carried forward, the late January lows of 1,270 to 1,310 will likely be retested.
Time to Pop the Corks?
We think it is too soon to tell. Mark Arbeter, S&P's chief technical strategist, thinks we need to successfully test the 1,270 to 1,310 range on the S&P 500 before stating that 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. Arbeter looks to sentiment as a contrary indicator. He would then need to see a close above the 1,395 recovery high on strong volume before he thinks this intermediate decline has run its course.
From a fundamental perspective, as we advised on Jan. 30, we believe the greatest risk is not in missing a short-term countertrend rally, but in becoming too aggressive too soon in the face of falling 2008 operating 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 underweighting of U.S. equities and a market-weighting of foreign stocks. We are encouraging an above-average exposure to cash to use once we think this correction has turned around or after the effects of a bear market have been endured.
We also currently recommend a defensive sector posture, favoring the S&P 500 Consumer Staples, Health Care, and Utilities sectors, while encouraging a reduced exposure to the more cyclical, and economically vulnerable, Consumer Discretionary, Financials, Industrials, and Information Technology sectors.