Breaking the 20% Threshold

On July 9, the S&P 500 joined the Dow Jones industrial average and the Nasdaq in bear market territory after declining 20%

Standard & Poor's Investment Policy Committee (IPC) regards a 20% decline in price from the peak of the bull market to be the start of a bear market. We have had nine bear markets since 1956. They have varied in magnitude from the decline of 20% for the market in 1990 to the 48.2% from 1973 to 1974 and the 49.1% from 2000 to 2002.

Many investors have begun to ask what happened to the price of the S&P 500 after the index fell 20%. History shows that the S&P 500 didn't cross the 20% threshold until two-thirds of the way through the overall decline. From 1956 to 2001, these nine bear markets lasted an average 14 months, yet it wasn't until the 9th month after the market top that the S&P 500 finally fell into bear market territory. This time was the same as the average: We topped out on October 9, 2007, and crossed into bear market mode almost exactly nine months later.

As a result, the IPC voted to reduce its year-end target for the S&P 500 to 1390 from 1490. David Wyss, S&P's chief economist, estimates the projected recession will now last 16 months, six months longer than the average recession since World War II.

S&P equity analysts now project earnings for the S&P 500 to rise 6.4% in 2008 vs. the 16% gain projected at the start of the year. We now see index earnings of 87.83 for year-end 2008, down from our initial estimate of 101.09. S&P's Energy group recently raised its 2008 average price for West Texas Intermediate oil to $131.34 a barrel from $120 as a result of disappointing non-OPEC supply additions.

However, the IPC did not alter its recommended asset allocation, which remains at 45% U.S. equities, 15% international stocks, 25% bonds, and 15% cash in the moderate ETF portfolio. The 1390 target, while 5% below the 2007 close of 1468, is nearly 10% above the July 3 closing level of 1263.

Influenced by the lower year-end target price, as well as sector-specific fundamental and technical considerations, S&P's Equity Strategy group raised the recommended weighting of the S&P health care and utilities sectors to marketweight from underweight, and reduced the recommended exposure to the consumer discretionary and industrials sectors to underweight from marketweight.

With equity volatility likely to remain high, and much of the bad news already discounted, we think investors will refocus on health care’s defensive qualities, allowing for better relative performance. The group is currently trading at 13.7 times 2008 estimated earnings, a discount to the S&P 500’s 14.4 multiple. In addition, the sector sports a healthier profit outlook, with 2008 estimated earnings expected to rise 11% vs. 6.4% for the 500.

We like the utilities sector for its defensive characteristics. Also, S&P equity analysts expect 12% growth in earnings, and the sector had an above-average 3.2% dividend yield as of July 8. We chose not to recommend overweighting the sector — it has a p-e ratio of 15.4 times 2008 earnings estimates, higher than the 500, and the group normally trades at a substantial discount to the overall market.

Since we expect consumer spending growth to slow to 0.3% in 2009 from projected 1.7% growth in 2008 and 2.9% in 2007, we downgraded the consumer discretionary sector. We forecast a 2008 operating earnings decline of 2%. Despite a year-to-date sector index price decline of 15% through July 3, the p-e on projected 2008 operating earnings was at 16.9. Higher energy prices, lower consumer confidence, and eroding earnings estimates give us little reason to believe this group will stage a sustainable rally.

Finally, we downgraded the industrials sector. With the U.S. economic slowdown accelerating and mid-cycle slowdowns now underway in Europe, the United Kingdom, Canada, and Japan, we believe this cyclical sector is vulnerable to p-e contraction, as investors increasingly question its future earnings growth outlook. In addition, we believe accelerating emerging market (EM) inflation and BRIC central bank rate increases give rise to concerns about decelerating EM gross domestic product growth. S&P analysts currently forecast a 5% gain in 2008 earnings, and the earnings outlook appears unclear.

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