Will the Market's Roof Cave In?

This drop feels catastrophic, but the long overdue pullback will soon present a good buying opportunity

It could have been worse. Back on Feb. 27, the S&P 500 dropped 3.5%. On July 26, it only fell 2.3%, but still—it felt pretty bad. Yet as market reactions to repeated events (subprime worries, Shanghai slumps, oil price shocks) become more and more muted, anecdotal evidence indicates that investors' personal reactions to these fear-inducing events appear to be just as strong. So much for getting desensitized to increased volatility. Maybe it's because of the breadth of the declines.

In market trading July 26, all 10 sectors in the S&P 500 lost ground, giving up 1.3% to 3.7% of their value. For the month, the S&P 500 is off 1.4%, and seven sectors are in negative territory. The year-to-date results look a little better, but it sure is discouraging to go from a 9.5% year-to-date advance for the broad benchmark just a few days ago, to only a 4.5% gain today.

Also discouraging: There was no place to hide. Only four of the 130 subindustry indexes in the S&P 500 increased on July 26: Trucking (+1.2%), Computer Hardware (+0.4%), Semiconductor Equipment (+0.4%), and Education Services (+0.3%). The worst subindustry performers were Real Estate Management & Development (which declined 6.8%), Aluminum (down 7.1%), and Tires & Rubber (off 9.0%).

Where Will it End?

Obviously, the big question is whether we've seen the worst of this sell-off. Stocks were volatile and trading modestly lower on July 27, as some nervous investors exited positions. What's more, one would have to assume that there was a slew of margin calls overnight to be addressed.

As to whether the end is near (end of this pullback, that is), Mark Arbeter, S&P's chief technical strategist, told me late Thursday (July 26) that he had expected to see attempted profit-taking over the coming weeks, after the Dow Jones industrial average crossed yet another millennium mark, but he didn't expect to see the decline encompass only two days (Tuesday and Thursday). Still, he was heartened by the panic-like trading he saw yesterday, as it indicated to him that this pullback may be near an end as many of the "loose hands" unloaded their shares. He still believes that the 1,450-1,460 range for the S&P 500—the highs from last February—will likely mark the low point of this decline.

Are investors' concerns about the continuing housing slump and widening subprime problems, the threat to completing announced leveraged buyouts (such as the buyout of Chrysler), concerns surrounding the possible drying up of strong mergers-and-acquisition activity, and the whispers of a possible credit crunch getting carried away? Maybe.

The Effect on Spending

Despite reassuring words from Fed governors recently that subprime effects won't spill over to the broader economy, the performance of the S&P 500 Financials sector has been telling a different story. Since June 1, while the S&P 500 has fallen less than 2%, the S&P 500 Financials sector has slumped more than 9%. And for good reason.

David Wyss, S&P's chief economist, believes that, when all is said and done, home prices will have tumbled 8% from their peak during the second half of 2005 to the trough in the first half of 2008. Existing home sales are already off 11.4% in the past 12 months, with supplies at a high of 8.8 months. The current unknown is how the continued softening in home sales and prices will affect consumer spending.

At the moment, Wyss still has faith that U.S. consumers will continue to spend, especially if employment growth remains healthy. He currently forecasts U.S. real GPD growth of 2.1% for 2007, rising to 2.7% in 2008 and 3.2% in 2009. He sees consumer spending climbing 3.1% this year, slowing to 2.8% growth in 2008, but recovering to 3.1% in 2009. He also believes that if the housing situation ends up steering the U.S. economy toward a wall, the Fed will likely step in and put us back on course by lowering rates prior to 2008, the current forecast for a rate cut.

Opportunities Ahead

Throughout the second quarter, while the S&P 500 topped 1,553, S&P's Investment Policy Committee (IPC) maintained its 1,510 yearend target, citing concerns about decelerating corporate EPS, the unresolved subprime issue, the lack of a 10% correction since this bull market started in May, 2003, and seasonality considerations. Arbeter and the IPC do not believe this pullback will morph into a bear market. And S&P does not forecast a recession in coming months. And S&P analysts see a turnaround ahead for S&P 500 EPS growth.

Add valuations that remain at a more than 10% discount to the average trailing operating p-e since 1988 (when S&P first started capturing operating results), and we conclude that a long overdue pullback will soon present a good buying opportunity.

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