As March comes to a close, we now see that it indeed came in like a lion and went out like a lamb. Month to date through Mar. 10, the Standard & Poor's 500-stock index declined 4.3% to 1273.37, bringing the total decline from the Oct. 9, 2007, peak at 1565.15 to 18.64%. Since Mar. 10, the "500" advanced 3.3% to 1315.20 through Mar. 28.
Reasons for this reversal of fortune, in our opinion, include the prospects that the first-half weakness in S&P 500 earnings per share will likely mark the bottom of this earnings contraction, and the realization that the Fed will do whatever it can to stabilize the credit and financial markets. In addition, investors may be wondering whether the equity market is bottoming along with consumer confidence. These words of future comfort don't mask the beating investors took during the first quarter of 2008, however, as the Nasdaq fell 14.7%, while the S&P 500, MidCap 400, and SmallCap 600 declined 10.4%, 10%, and 8.4%, respectively.
Within the S&P Composite 1500 index (our U.S. total market index), all 10 sectors posted year-to-date declines in price, ranging from tumbles of 4.2% or less for the Consumer Staples and Materials sectors, to slumps of 16% or more for the Information Technology and Telecom Services groups. Finally, despite double-digit advances for the Trucking (+14.6%), Homebuilding (+12.3%), and Oil & Gas Exploration & Production (+11.6%) subindustries, 117 (85%) of the 137 subindustry indexes in the S&P 1500 fell during the quarter, led by declines in excess of 30% for Oil & Gas Refining & Marketing (-30.6%), Commodity Chemicals (-33.2%), Education Services (-35.2%), Wireless Telecom Services (-37.6%), Managed Health Care (-38.7%), and Consumer Electronics (-38.9%).
With such results, it's no wonder price volatility has been on everybody's lips. Adding to this concern, the S&P 500 has registered 16 one-day declines of 2% or more in the past 12 months, which is four times the annual average since 1950, and on Mar. 18 the "500" surged 4.24% to record the 17th-largest one-day increase in nearly 60 years. What investors are now wondering is if this wide variation in volatility is a harbinger of even worse things to come.
Possibilities of Volatility
If history is any guide (it's never gospel), it does not appear to us that volatility has become severe enough to signal the worst is behind us. Whenever the three-month average of the S&P 500's daily high-low volatility has peaked above 2.55% (two standard deviations above the daily average of 1.45%), the S&P 500 has been about a month away from the bottom of a bear market or sharp and swift corrective action. Since 1962, the bottoms of the bear markets of 1962, 1970, 1973-74, 1987, and 2000-02, as well as the corrective actions of 1980 and 1998, were identified as being close at hand by a spike in trailing three-month daily intraday price swings for the S&P 500. And while this volatility measure did issue a false signal one year into the 1973-74 bear market, it successfully identified the end was near for the five worst market declines since 1945, which declined an average 39%.
Today, the trailing three-month volatility index is below the threshold that would signal a bottom is near. There are two ways one could read this: First, we are in a sideways trading period that will be followed by further downside action to be accompanied by a pickup in volatility. Only after the volatility index has peaked above the 2.55% level would we feel more confident that a bottom was close at hand.
The other possibility is that, like the more slowly developed and less volatile and deep bear markets of 1966 (which fell 22%), 1982 (-27%), and 1990 (-20%), this corrective action may end up being as subdued as these three, which, as a whole, declined an average of 23%.
The Worst May Be Over
S&P's Investment Policy Committee believes that from economic, fundamental, technical, and historical perspectives, the second scenario is most likely that the worst is behind us.
We see inflation-adjusted gross domestic product (GDP) declining during the first half of 2008, but then advancing in the second half as a result of the economic sugar rush offered to American consumers in the form of a tax rebate, as well as the effects from a year's worth of Fed rate cuts. The yet-to-be-resolved worry is whether U.S. GDP growth will again slip into negative territory once the tax stimulus has worn off.
Fundamentally, we don't expect to see 2008 go down in the S&P 500 earnings annals as a repeat of 2007. S&P equity analysts project the market-cap weighted S&P 500 to post a 16.5% increase in EPS for the year, led by double-digit EPS recoveries by companies in the Telecommunications Services, Financials, and Information Technology sectors. Eight of the 10 sectors in the S&P 500 are expected to see double-digit earnings growth in 2008, with only the Industrials and Materials sectors likely to see single-digit advances. Bear in mind, however, that projected earnings increases may tell an overly optimistic story, particularly with financial companies, as mark-to-market writedowns are typically not included in forecasts.
Onus Now on the Bears
While we believe we haven't performed enough penance to atone for the sins of subprime, we don't tell the market how far it has to fall; it, after the fact, tells us how far it has fallen. Technically speaking, therefore, we believe the onus is now on the bears to prove the 1270 level of the S&P 500—which was reached on an intraday basis on Jan. 23 and successfully retested on Mar. 10, in our opinion—will not hold and we will eventually break below 1250 and thereby enter into a new bear market. What's more, investor sentiment is extremely negative, which we find to be a typically reliable indicator of major market bottoms.
Historically, the correction of 2007-08 is shaping up similarly to the mini-bear market of 1990. Not only did the S&P 500 and U.S. economy peak within two months of each other this time as last, but the 19.9% decline in 1990 is close to the 18.6% correction experienced from Oct. 9, 2007 through Mar. 10, 2008. Also, while the S&P 500 declined 13.7% six months after the Fed started cutting rates in 1990—one of only five times since 1945 that the S&P 500 was not higher six months after the Fed began an easing cycle—the S&P 500 was off 13.2% six months after the Fed started cutting rates back in September, 2007.
While we have been comfortable advising investors to fight the Fed (i.e., expect market declines in the wake of rate cuts) in the near term, we are not so confident it will be the correct advice longer term.