A Rough Patch, Then a Rally?

Standard & Poor's thinks a potential August shakeout may help set the market up for a yearend advance

From Standard & Poor's Equity Research

The S&P 500 posted its high for the year-to-date on May 5 at 1325.76, registering a 6.2% return at the time on the expectation that the 16th Federal funds rate increase, widely anticipated to occur at the May 10 FOMC meeting, would be its last for this tightening cycle.

But after the meeting the market fell when investors got the impression that the Fed would continue to raise rates indefinitely, or at least, until the economic data told them that a slowdown was in the making. And those concerns were borne out by an additional hike on June 29 (see BusinessWeek.com, 6/30/06, "Bernanke's Timely Balm").

Additional factors in the market's recent decline, in our opinion, included seasonal weakness, stubbornly high oil prices, and political tensions with Iran. The S&P 500 subsequently declined 7.7% through the June 13 low.


  There is an old saying, "the market is never wrong, interpretations are." S&P believes most investors interpret the market's recent performance as telling them:

1. Investors are underestimating how far the Fed will go in subduing inflation, thereby

2. Overestimating economic growth in the remainder of 2006 and into 2007,

3. Overestimating EPS growth,

4. Underestimating the threat of recession, and

5. Underestimating the rotation toward cash or traditionally defensive sectors of the market

S&P believes that these interpretations are wrong, however. We believe that since the Fed's June 29 press statement did not add to the already elevated level of uncertainty, investors will refocus their attention on second-quarter earnings reports and forward guidance that may prove to be the catalyst for a modest relief rally in July, a traditionally positive month.


  Come the dog days of August, however, we think investors will again focus on the likely action of the Fed at that month's FOMC meeting, which may cause equity prices to experience the long-overdue shakeout of between 10% and 15%. In the end, we believe this correction within a bull market—and not the beginning of a new bear market—will set up the S&P 500 for an end-of-year rally as a result of clarity offered by the end of the Fed's rate-tightening program and a conclusion to mid-term Congressional elections.

S&P's Investment Policy Committee is recommending a 65% exposure to equities and a 35% holding in fixed income, indicating a five-percentage point bias toward equities, relative to our neutral 60% equities/40% fixed income benchmark.

We recommend placing the additional funds in the international arena, due to healthy EPS growth prospects overseas and the projected benefit from currency related tailwinds. We also believe Asia—despite the second-quarter declines in key regional equity indexes—offers better investment opportunities than does Europe.


  On a sector level, S&P's Equity Strategy Group recommends overweighting the Energy group, reflecting the likelihood of elevated energy prices throughout 2006 due to, among other things, geopolitical tensions and low spare production capacity as a result of increased global demand. S&P Equity Strategy also recommends overweighting the Financials sector, believing an imminent end to Fed tightening will act as a catalyst for this rate-sensitive sector.

Conversely, S&P recommends underweighting Consumer Discretionary sector, which has limited earnings visibility and low S&P Quality (earnings and dividend growth) ranks, and will likely be hindered by high gasoline prices and a weaker housing market, which could dampen consumer spending through yearend.

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