Stovall: Making Sense of the Meltdown

S&P's chief investment strategist cautions against stepping in to the battered financial sector amid the current market turmoil

Now that Lehman Brothers (LEH) has announced its intention to file for bankruptcy, and Merrill Lynch (MER) has agreed to be acquired by Bank of America (BAC) for $50 billion, they join Bear Stearns, Countrywide, Fannie Mae (FNM) and Freddie Mac (FRE), and IndyMac as fallout casualties from the credit and housing crises. What's more, with American International Group (AIG) attempting to resolve its own challenge of monumental proportions, we can at least say we've gone through the first half of the alphabet. The second half is next.

How will it likely play out? Based on the recommendations by S&P equity analysts to sell National City (NCC), Wachovia (WB), and Zions Bancorp (ZION), investors in these shares probably shouldn't wait around to find out.

But what about investors in the overall sector? Year-to-date through Sept. 12, the entire group has taken it on the chin, falling nearly 28%, or almost twice the decline of the Standard & Poor's 500-stock index. What's more, 14 of the 20 subindustry indexes are in the red for the year, with 10 of these slumping more than the market. Two sectors—Multi-line Insurers and Thrifts & Mortgage Finance—have led the way with declines in excess of 60%.

If History Is Any Guide

Does this mean we are only halfway through this carnage? From the Oct. 9, 2007, peak in the S&P 500 of 1565 to today's indicated open of 1215, amazingly, the S&P 500 has suffered only a 22% slide. This "baby bear" market compares quite favorably with the average 27% sell-off for all "garden variety" bear markets (declines of 20% to 40%) since World War II. Including the two "mega-meltdowns" (40%+ declines) of 1973-74 and 2000-02, the average decline has been closer to 32%. In other words, for the S&P 500 to approach "average" bear market levels, we need to experience another 5-to-10 percentage-point sell-off in prices.

The answer to the earlier question is that we probably are more than halfway through this overall bear market. Unless, of course we slip into another mega-meltdown. History says we won't, as these 40%+ declines are typically separated by 30 years—the one prior to 1973-74 occurred in the early 1940s. But history guarantees nothing, so I can only play the odds. As a result, I wouldn't try to be a hero and start a major buying campaign.

From a sector standpoint, unfortunately, it's unclear as to whether we are more than halfway to the bottom of this Financials free fall. In the last seven bear markets, including this one, while the S&P 500 fell an average 33%, the S&P Financials group declined an average 28%. These averages are fairly encouraging. However, in the 1990 bear market—which I think more closely resembles the cause of this bear, due to the savings and loan crisis and the junk bond meltdown—the S&P 500 Financials sector slumped 36%, vs. the S&P 500 index's decline of just 20%. With the S&P 500 Financials sector index already off 28%, we would need to experience another stock market decline on the order of 1973-74 to say we are only about halfway there. That comparison, while not currently projected, isn't out of the question.

How Will Today Unfold?

In the past 34 years, there have been at least five failures or takeovers of major financial firms. It goes without saying that the start of today's trading day will likely be very ugly. Again using history as a guide, but not gospel, we see that the S&P 500 held up fairly well in the immediate period after the demise of five major institutions since 1974: Franklin National Bank, Penn Square Bank, Continental Illinois Bank, E.F. Hutton, and Drexel Burnham Lambert. In three of the five observations, the S&P 500 was higher three days after the event than three days before.

What's more, 1) all failures occurred within the same year of the market bottom; 2) the time difference between the failure and the eventual end of the market decline was an average of only two months; and 3) three of the five failures occurred within seven days of the bottom. Therefore, I think the most telling aspect of today's opening will be the follow-through. If the market's action over the next few days is the reverse of the action following the takeovers of Freddie and Fannie, meaning that the market holds at the recent 1215 low on the S&P 500, then the worst may be over.

If not, then the group—as well as the overall market—will likely experience further declines as Wall Street attempts to identify additional failures and their likely effects on the financial system and overall economy.

Volatility—A Likely Near-Term Companion

In an understatement, the S&P 500 has taken investors' emotions on a volatile ride of late. On Sept. 9, the index fell 3.4%, which followed a 3.0% decline on Sept. 4. And today looks to be a whopper as well. Is this normal? The S&P 500 recorded one-day declines of 2% or more an average of 4.7 times per year since the 1960s. Yet in the past 10 years, that average has risen to 11 times per year. In the latest 12 months, moreover, we have suffered through 20 such single-day emotional roller-coaster rides. Not surprisingly, investors again are wondering if this is a warning of a higher-magnitude tremor or merely a mid-July aftershock. Our definitive conclusion is…that depends.

If this current bear market concludes with only a 22% sell-off—as was experienced from Oct. 9, 2007, through July 15—we may not get a sharp end-of-bear capitulation. As with the less volatile and shallow bear markets of 1966, 1982, and 1990, which declined an average of 23%, the baby bear market of 2007-08 may end up being as subdued as these three.

If, on the other hand, this current bear market ends up delivering a peak-to-trough decline that is closer to the average bear market, which we now believe to be a more likely scenario, then a final shakeout will be needed. Since 1962, the bottoms of the bear markets of 1962, 1970, 1973-74, 1987, and 2000-02, as well as the corrective actions of 1980 and 1998, were identified as being close at hand by a spike in trailing three-month daily intraday price swings for the S&P 500. And while this volatility measure issued a false signal one year into the 1973-74 bear, it successfully identified that the end was near for the five worst bear market declines since 1945 that averaged a decline of 39%.

EPS Angst

A possible triggering event could be last-minute downward adjustments to third-quarter S&P 500 operating earnings estimates, which S&P equity analysts currently see rising 4%, producing the first positive quarter in a year. Barring additional unexpected shortfalls, however, it appears as if the S&P 500 will finally be emerging from this four-quarter waterfall of red ink. Estimates now call for the Energy sector to post the greatest advance, at 55%, followed by year-over-year gains of from 10% to 14% for four other sectors. Only the Financials group is expected to post a decline this quarter, as the fog surrounding this foundering sector has yet to lift. For the full year, we forecast earnings-per-share declines for only the Consumer Discretionary and Financial sectors, yet project healthy growth prospects for the remaining eight.

Foundering Financials

S&P's Equity Strategy Group, considering fundamental outlooks from our financial-services equity analysts and evaluating technical considerations, recommends maintaining an underweighting toward the S&P 500 Financial Services sector. We think the chances are high that more data suggesting a bottoming in the housing market, combined with an easing of credit pressures, will be required before a change in recommended exposure is warranted.

In summary, we believe it prudent to wait for additional confirming factors, such as third-quarter EPS reports and guidance, as well as upcoming housing reports, before revisiting our recommended allocation on the Financials sector.

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