On Feb. 27, 2007, we were shaken by the first one-day decline of 2% or more in the Standard && Poor's 500-stock index in nearly four years. The real surprise came from the lack of such a decline for so long a period. Since 1950, we experienced an average of a little more than four per year, indicating that 2% declines occur about 2% of the time. In the past year, however, we suffered through a total of 16 such one-day sell-offs, with 11 in calendar year 2007. Only the years 2002 (with 29 one-day declines of 2% or more), 1987 (20), 2000 (19), 1974 (15), 2001 (13), and 1998 (12) saw more.
Of course, with five sell-offs already this year, we could end up setting a new annual record. If it's any consolation, however, the subsequent years saw equity prices rise an average 8.9% and post advances four of six times.
Further Erosion Likely
The S&P 500's performance in February was certainly true to the month's recent reputation as a difficult period for the market, falling 3.5%, the fourth decline in a row and the sixth decline of the last 12 Februaries. Since 1945, the S&P 500's average price performance and frequency of decline in February is second only to September's. This year, besides typical seasonality, we can blame the market's skittishness on eroding earnings-growth prospects, rising inflationary expectations, and the market's discounting of an even more severe recession than was initially anticipated. Price weakness was not confined to the S&P 500, however. The S&P MidCap 400 slumped 2%, while the S&P SmallCap 600 fell 3.1%.
Globally, the story was the same, as the S&P Global 1200 edged lower by 0.68% during the month, as additional declines in the S&P Euro350 (–1.32%) and S&P/TOPIX 150 (–1.33%) were offset by advances in the S&P Latin America 40 (7.43%) and the S&P BRIC 40 (8.69%).
This March, at least early on, we may experience additional market madness. This week alone we brace ourselves for several important economic reports. In particular, we see 1) the February ISM Manufacturing and Non-Manufacturing reports showing readings below 50 (implying economic contraction), 2) January factory orders emulating last week's durable goods orders report by reversing the prior month's advance, and 3) the monthly nonfarm payroll report registering an increase of 60,000 in February and the unemployment rate ticking up to 5% from 4.9%.
Later this month, OPEC will decide on production cuts, while Federal Reserve policymakers will see whether they should lower the Fed funds rate by 50 basis points to 2.5%, as we and the rest of the Fed watchers expect, and issue a statement that offers hope of additional rate cuts as early as April. Analysts will also be gearing up for the first-quarter earnings reporting season and bracing for negative pre-announcements from corporations. S&P equity analysts see operating earnings for the S&P Composite 1500 (consisting of the S&P 500, MidCap 400, and SmallCap 600 indexes) rising only 1.2% this quarter as an expected 12% decline in year-over-year results for the Consumer Discretionary sector and a 28% further erosion in EPS for the Financials group offset double-digit advances projected for 5 of the 10 sectors, led by Telecommunications Services (45%) and Energy (35%).
From a technical perspective, Mark Arbeter, S&P's Chief Technical Strategist, tell us that last week's equity market decline sets up the possibility of an additional test of the late January lows. He sees the major trend as still firmly bearish, and believes that another down leg could take place.
S&P's Investment Policy Committee continues to recommend a cautious and patient stance toward equities and waits for confirming technical evidence that would suggest the worst is over. We believe the market is likely to improve during the second half, and we are maintaining our yearend target of 1560 on the S&P 500, acknowledging the anticipated benefits to the economy and market from an aggressively easing Federal Reserve and short-term boost from the economic stimulus package, a resulting recovery in the U.S. economy, and the expectation of double-digit earnings growth, according to S&P equity analysts.
Ever since the January consumer and producer price indexes came out, I have been barraged by the question: "Are we slipping into a period of stagflation, such as in the 1970s?" Thinking back to the decade that encompassed my high school and college years, I am reminded of bad hairstyles, ineffectual Presidents, unpopular military engagements, speculation about Fidel Castro, soaring oil and commodity prices, rising unemployment, and an equity-market meltdown that erased more than 45% of the value of the S&P 500. Sorry. Which decade was I talking about?
Adding to these selected similarities is the mirroring message from the performance of industries and sectors within the S&P 500. During the 1970s, based on the average price performances for the subindustries within the 10 sectors in the S&P 500 (S&P didn't compute sector-level data back then), the four leading sectors in descending order were Energy, Materials, Utilities, and Industrials. This time around, the only difference is the inclusion of the Consumer Staples sector. What's more, Information Technology was among the worst performers in both periods.
Certainly there are surprising similarities, but let's not confuse stagflation with recession. To quote the Dictionary of Financial and Economic Investment Terms (published by Dow Jones), stagflation is "the previously unprecedented combination of slow economic growth and high unemployment (stagnation) with rising prices (inflation)." S&P Economics is projecting U.S. real gross domestic product to decline 0.7% in both the first and second quarters of 2008 vs. the 3.2% advance experienced in all of 1979, and believes that whenever the National Bureau of Economic Research gets around to calling the current situation a recession, they will likely say it started in the fourth quarter of 2007. So the first inconsistency in the stagflation argument is today's expected decline in economic activity vs. the growth experienced in the late 1970s. Granted, we believe the recession will not last forever. We see it ending in the third quarter of this year, and project U.S. real GDP will rise 1.2% during all of 2008.
The other inconsistent comparison with the late 1970s has to do with the current rate of inflation and unemployment, in our opinion. We believe that while the inflation rate, as measured by core CPI (which excludes food and energy prices), will likely creep a bit higher early in 2008—since it is a lagging indicator—it will then trend lower as the recession places downward pressure on prices. By our forecast, the full-year 2008 average increase of 2.5% will equal the most current reading and be quite a bit lower than the 11.3% registered in the final month of 1979.
The bond market's outlook for inflation is also quite a bit more subdued this time around as seen in the 3.53% yield on the 10-year Treasury note, versus the 10.33% yield recorded in late 1979. Finally, while today's 4.9% unemployment rate will probably rise up to meet the 6% rate recorded in December, 1979, we don't see unemployment becoming a major issue in the years ahead, as we project the average quarterly rate to top out at 5.85% during the second half of 2009.
So there you have it. We don't believe we are in a similar stagflationary period as last seen in the 1970s, since 1) U.S. real GDP is currently forecast to decline over the coming two quarters, not advance; 2) the current core CPI reading of 2.5% is a far cry from the 11.3% seen in December in 1979; and 3) unemployment at 4.9% is well below the 6% recorded in 1979. We believe the biggest difference between these two periods lies in the variance of inflation indicators. While we see the CPI edging higher in the near term as the Fed continues to lower interest rates in an effort to fight recession, we also see the Fed reversing its interest-rate course early in 2009, after it believes it has secured the footing under this teetering economy.
Investing in Inflationary Expectations
Investors looking for opportunities in the subindustries that have established leadership positions this decade may wish to consider the following groups, which were selected by their superior performances (greater than a 100% advance in the past eight years), as well as their currently high S&P cap-weighted average STARS rankings (of 4 or higher). Also listed are the stocks within each group that carry 5-STARS rankings.
|S&P 1500 Sectors||Average STARS||% Change 2000-08||5-STARS Stocks|
|Tobacco||4.9||307.0||Altria Group (MO), $73|
|Integrated Oil & Gas||4.5||136.8||Exxon Mobil (XOM), $87|
|Trading Companies & Distributors||4.2||123.3||Fastenal (FAST), $41|
|Apparel, Accessories & Luxury Goods||4.1||130.0||Coach (COH), $30; MaidenForm Brands (MFB), $12|
|Construction & Engineering||4.1||103.7||Jacobs Engineering (JEC), $80|
|Managed Health Care||4.0||372.0||Aetna (AET), $50|
|Aerospace & Defense||4.0||111.1||Rockwell Collins (COL), $59; Goodrich (GR), $59|
|Oil & Gas Drilling||4.0||204.8||Noble Corp. (NE), $49|
|Health-Care Distributors||4.0||125.9||McKesson (MCK), $59|
Source: Standard & Poor's Equity Research