Stocks: After the Bear's Rampage, What Next?

Amid the current turmoil, S&P thinks investors will return their focus to equities as valuations improve and yields on other assets shrink

There was bad news everywhere you looked as St Patrick's Day dawned on Wall Street. Before the Mar. 17 market open, S&P 500 futures were down nearly 35 points. Foreign markets were trading 3%-5% lower on the day.

Investors around the globe are wondering if Bear Stearns (BSC) is the Drexel, Burnham of this market turmoil, sounding the final lap of this downward spiral, or simply the first of many major tombstones to be erected in remembrance of financial institutions that succumbed to Subprime Influenza.

With the Federal Reserve's Mar. 16 move to cut the discount rate by 25 basis points, as well as a likely Fed funds rate cut of at least 75 bps at the central bank's Mar. 18 policy meeting and several prior actions to add liquidity, the Fed is attempting to stimulate and stabilize our financial institutions and economy in an effort to avert a more serious recession.

Unfortunately, the Mar. 16 action likely stoked rather than soothed investors’ fears, yet one can’t be too critical unless one has a better solution to offer.

It goes without saying that 1270 on the S&P 500 may not be the low for this market decline. More likely is that the “500" retreats to the 1170 level, according to Mark Arbeter, S&P’s chief technical strategist, who identifies it as a critical support and retracement level. It would also represent a 25% decline from the October 9, 2007 high on the S&P 500 of 1565 and equal to the average equity market sell-off in anticipation of economic recessions since 1945.

We think the stock market, while currently focusing on actions of the Fed and continued uncertainty surrounding the credit markets and economy, will – around the 1200 level or below – begin to return to a forward-looking discounting mechanism as valuations become compellingly attractive. We believe investors will eventually see that the safety of U.S. Treasuries will not offer sufficient protection against inflation and taxes, as witnessed by the difference between the current 3.33% yield on the 10-year T-note and the earnings yield of 6.68% for the S&P 500 based on perating earnings for the second quarter of 2007 through the first quarter of 2008 (based on analyst.

At a 25% bear market decline level, we note that the trailing price-to-earnings ratio on the S&P 500 would fall from the current 15.2 times (at the Mar. 14 close of 1288) to 13.6 times and represent a near 30% discount to the average p-e of 19.3 times since S&P started capturing operating earnings in 1988. In addition, based on S&P equity analysts’ S&P 500 estimated operating EPS of 96.71 for 2008, the P/E ratio would decline to 12.1 times. And should that forward p-e become the year-end actual, it would be the lowest valuation since the first quarter of 1989 – more than two recessions and bear markets ago.

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