Behind the Market's October Surprise

The Oct. 1 rally sent the Dow industrials back into record territory. S&P thinks stocks could finish the year with additional gains

How would you expect the equity markets to react to huge write-downs by global financial institutions associated with subprime mortgages, followed by the release of weaker-than-expected economic data? The Dow Jones industrial average shot up 191 points (+1.38%) on Oct. 1, as did many of the other U.S. equity benchmarks, leaving market commentators to figure out how to explain this move.

The following are beliefs we think investors may have embraced to justify the Oct. 1 advance:

The worst of the credit crunch is over. The third-quarter earnings write-downs by Citigroup (C) and UBS (UBS), two global financial behemoths, appear to us to have done the markets a favor by beginning to quantify the overall magnitude of the mortgage mess and signaling the nadir in subprime-related earnings impairment.

In Citi's case, the company said it expects third-quarter net income to fall about 60% from the prior-year quarter. As S&P analyst Frank Braden pointed out in an Oct. 1 note, the decline is largely due to write-downs in leveraged loan commitments, losses on the value of collateralized debt and loan obligations, losses in fixed-income trading, and higher credit costs in Citi's global consumer segment. Braden believes Citi's results will improve during the fourth quarter, but he lowered his third-quarter earnings per share (EPS) estimate to 45 cents from $1.13, and cut his full-year 2007 estimate to $3.89 from $4.58. He also lowered S&P's 12-month target price on Citi shares by $2 to $61. Braden kept his strong buy rating on Citi shares.

The EPS bar is again too low. Next week, third quarter earnings reporting season begins in earnest. Like the beginning of the first-quarter EPS season, when S&P analysts—along with the Street as a whole— projected the S&P 500 to post only a 3% year-over-year increase in operating results (but ended up with an earnings advance of 8%), the current 2.5% growth expectation may be too low of a bar to present much of a hurdle to company managements' well-honed EPS guidance capabilities. What's more, as weekly EPS projection data are received from our Index Services group, we have found our 2008 earnings estimates to be rising, not falling, and now stand at a 13% projected growth.

The Fed to the rescue. As a result of the Oct. 1 report that ISM's U.S. manufacturing index declined to 52 in September from 52.9 in August, combined with the weaker University of Michigan consumer sentiment index released Sept. 28, we think many investors now believe that the Fed will cut rates again at the Oct. 30-31 FOMC meeting and possibly at the December meeting as well, particularly since the core PCE deflator—the nationwide indicator of the average increase in prices for all domestic personal consumption, supposedly the Fed's favorite measure of inflation—registered a 1.8% year-over-year increase, which is well within the central bank's 1%-2% unofficial comfort zone.

Short-covering. For several weeks, Mark Arbeter, S&P's chief technical strategist, has been telling readers that the abundance of bears—as indicated by extremely bearish levels of put/call ratios, odd-lot short sales, and investor/adviser polls—could soon turn into a positive for equity prices as higher prices may force traders who are short the market to cover their positions. The equity gains could also prompt investors with an abundance of cash on the sidelines to get back in before the new leg of the bull market passes them by.

Favorable seasonal factors. We have now entered the fourth quarter—traditionally the strongest of the year for the market. Since 1945, the S&P 500 has advanced 4.1% on average in this final three-month stretch, vs. gains of 2.3%, 2%, and 0.3% for quarters one through three, respectively. What's more, the S&P 500 has risen during 79% of all fourth quarters since World War II.

So there you have it. How much further could this advance go? Mark Arbeter thinks that should the S&P 500 break above its all-time high at 1553, it could soon challenge the 1600 level. S&P's Investment Policy Committee sees the S&P 500 closing the year at 1560, a 10% gain for the year.

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