Stocks: A Correction in Confidence

While housing and credit worries weigh on investor sentiment, S&P believes fundamentals remain solid, and doesn't think a bear market is at hand

The global equity markets continue to decline, not stopping very long at technical analysts' support levels.

The Standard & Poor's 500 closed on Aug. 14 at 1426.54, below the 1430 support level. The "500" is now off 8.1% from its July 19 closing peak of 1553, officially referred to as a pullback. We'll have to wait for a 10% decline below 1397 before we can tag the sell-off as a correction. Beyond that, Mark Arbeter, S&P's chief technical strategist, believes it is possible the S&P 500 may fall enough to test the 1325 level (a previous high set in May, 2006) before this correction has run its course.

Why all the pessimism? I think investors are questioning their previously unshaken confidence in our economy, markets, and public officials.

Consumer Spending?

The U.S. housing market is experiencing its first national decline since the Great Depression. Home prices are down about 3% nationwide, and are expected by David Wyss, S&P's chief economist, to bottom out by the second quarter of 2008, after falling 8%. As home values head south, consumers are no longer able to use their homes as a giant ATM, which many feel will reduce the wealth effect and eventually slow consumer spending.

Investors have always speculated that the American consumer can't live beyond his means forever, but have dismissed these unnerving statistics as "government-supplied guesses that will later be revised away." But now that Wal-Mart (WMT) has reduced its earnings guidance for the remainder of the year, maybe forecasts of a slowdown will finally come true. And since the consumer represents two-thirds of the U.S. economy, a falloff in spending may call into question the forecast of 2%-3% real gross domestic product growth over the coming two years.

Concerns surrounding subprime make investors feel as if global investment funds have been infected with a financial version of the bird flu virus. And because of the willingness by "masters of the universe" to go further out on the risk curve in order to squeeze out a few more basis points in return, we are being informed daily of yet another fund managed by the brightest minds on Wall Street that is now in need of a bailout in the billions.

Questioning the Fed's Actions

Where is the Fed in all of this? Investors are interesting beings. When equity prices are rising, they are angered when the Fed attempts to instill a bit of sobriety into the markets by removing the proverbial punchbowl. Yet when financial markets experience the eventual convulsions of overindulgence, investors point the quivering finger of blame at authorities for not protecting us from ourselves. Again the actions of Fed officials are being questioned. Should it have:

1) Lowered rates as far as it did from 2001-06? (Does anyone remember the recession of

2001 or the 2000-02 bear market?);

2) Kept rates low for so long? (I remember deflation as a very real worry); or

3) Not stated that it will lower the Fed funds rate at the first whiff of worry (seems to me that the inflation indicators have yet to signal an all clear).

Where will all this end up? Possibly with a correction of as much as 15%. But I don't believe a new bear market is at hand, because I have confidence in the forecasting ability of our economists and analysts. S&P still believes economic growth remains on solid ground. In fact, based on recent retail sales and trade deficit data, we will likely see an upward revision to second-quarter gross domestic product data. Also, our recently updated GDP forecasts are now projecting 2% growth this year and a 2.7% advance next year.

Attractive Stock Valuations

From an earnings standpoint, our S&P 500 estimates for 2007-08 are rising, not falling. As a result, valuations are looking increasingly attractive.

Finally, I think the Fed will continue to inject liquidity (and confidence) as needed. So I believe time will eventually be the great neutralizer of this volatility. I think once this correction has shaken off the group of greedy quant-fund managers who ventured too far out on the risk curve, this market's limbs will bend back to normal.

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