Making Sense of the July Swoon

S&P says that while the recent equity downdraft may signal a correction within the current bull run, a bear market isn't likely to emerge

July was not kind to equity investors. In response to widening subprime worries and a continued weakening of new- and existing-home sales and prices, the Standard & Poor's 500-stock index fell 3.2% on the month, while the S&P MidCap 400 declined 4.4%, and the S&P SmallCap 600 slumped 5.1%. Eight of the 10 sectors in the S&P 500 were in the red, with Financials posting the largest decrease of 8%. Energy and Industrials were the only gainers on the month.

Year to date, all three benchmarks and eight of the 10 sectors are still in the black, with Energy, Industrials, Materials, and Telecom Services showing double-digit advances. International benchmarks also slid in July, with the MSCI-EAFE index off 2% and the MSCI-Emerging Markets index down 1%. At this point, all we can happily say is "Bye-bye July!"

But don't get your hopes up just because we've entered a new month. The S&P 500 posted its worst average monthly performances in February, August, and September, the only months since 1945 to record declines. As a result, the S&P 500 recorded its worst results during the third quarter, implying that we are at just the beginning of a seasonally weak period.

Sell-Off Semantics

On July 19, both the Dow Jones industrial average and S&P 500 set all-time closing highs: the DJIA at 14,000.41 and the S&P 500 at 1553.08. Since then, these indexes suffered pullbacks of 5.6% and 6.3%, respectively. Other global indices recorded all-time or recovery highs last month, only to experience similar slides. As I have said in previous articles, S&P's Equity Strategy Group believes we are in the midst of a pullback, poised for a correction but not likely to enter into a new bear market. The difference between these terms is a matter of percentages.

From S&P's perspective, when equity prices fall from 0% to 5%, we believe that's just normal market volatility as investors digest recent gains. We refer to a decline in the 5%- to-10% range as a pullback, which also is a fairly common and not too serious event from an investment psychology standpoint.

Investors begin to feel the pinch when corrections roll around, however, as they lop off 10% to 20% of the market's value. As of July 31, the DJIA, S&P 500, and Nasdaq each fell more than 5% from recent highs. International equity benchmarks, however, as seen in the MSCI-EAFE (a benchmark of non-U.S. large-company stocks in developed countries tracked in an ETF with the ticker EFA, recently trading at $79) and MSCI-Emerging Markets (EEM, $137) are still within the confines of normal volatility. While not as common as pullbacks, every acknowledged bull market since 1970 has had at least one correction within it before resuming the bull market's progress. In fact the bull market of 1990-2000 saw five bull-market corrections.

I say "acknowledged bull market," since I believe an investor has to know that we are in a new bull market before the pain of a correction can be fully appreciated. We experienced a 15% correction in late 2002 to early 2003 after the S&P 500 bottomed on Oct. 9, 2002, but that was before early May, 2003 when the S&P 500 finally advanced 20% from that bear market low and investors knew that we had entered a new bull market.

Brace for the Bear Market Blues?

Bear markets have come along once every four and a half years since 1945. Interestingly, this bull market just passed the four-and-a-half-year mark in early April, so from a calendar perspective, we're due. But I have always said that history is a good guide and never gospel. S&P believes we are not heading for a new bear market, since the economy and market's fundamentals have not changed, in our opinion.

Economically speaking, David Wyss, S&P's chief economist, still believes that the subprime problem—despite continuing to pressure the auto and housing-related industries—will not spill over to the rest of the U.S. economy and throw us into recession. What's more, S&P's equity analysts are still projecting healthy earnings advances for 2007 (we're currently seeing an 8% rise in S&P 500 operating results) and 2008 (+12%).

Finally, we don't think this market will topple under the weight of elevated price-to-earnings ratios. The S&P 500 is currently trading at a p-e of 16.3 times trailing 12-month operating earnings, which is far below the peak of 30 times in 2001 and more than 15% below the average since 1988 (when S&P first started capturing operating results). The p-e falls to 15.4 times on 2007 estimated results and to 13.8 times based on 2008 forecasts. Based on GAAP (generally accepted accounting principles), we are trading at a 20% discount to the average since 1988 and less than 200 basis points above the average since 1935.

Fear Led To Downturn

In our opinion, this recent market action has been driven by the fear of an impending recession brought on by 1) slumping housing prices, which will likely generate a cascading impact on consumer sentiment, expectations, and consumption, and 2) the subprime lending woes, which may cause financial institutions to curtail lending practices, thus slowing leveraged buyout activity and limiting corporate expansion possibilities.

Since I have already stated that we don't currently see a recession on the horizon, we believe the best way to get a handle on how far this market's decline will extend is through technical analysis. Mark Arbeter, S&P's chief technical strategist, recently stated that critical support for the S&P 500 lay in the 1450-to-1460 area—the S&P 500's February high. We closed squarely in this area on July 31.

Should we break below this zone, the market will likely be buoyed by long-term chart support, which comes in around 1390, or 10.5% below the recent high of 1553. Below this level, the market may need to retrace its steps to the 1325 area, the "500's" peak in May, 2006, which is nearly 15% below the July 19 high. We currently don't see the carnage extending beyond a mid-correction magnitude.

In all, we believe that while a bull-market correction is likely at hand (and long overdue) we see the economy's and market's fundamentals eventually righting this market before a new bear emerges.

    Before it's here, it's on the Bloomberg Terminal.