Standard & Poor's Equity Research believes a sharp rise in U.S. equity volatility can be explained by growing fears that a looming recession will slow corporate earnings-per-share (EPS) growth in the months ahead.
In addition to long-standing worries about U.S. housing weakness and high energy prices, recent unprecedented writedowns at leading financial institutions have investors concerned that tightening U.S. credit conditions will slow employment and wage growth, finally breaking the back of the U.S. consumer, say our analysis.
Looking ahead, the question facing investors is whether recent weakness represents a healthy correction or the beginning of a new bear market. While limited visibility regarding macroeconomic conditions makes this a challenging call, we believe that with the Standard & Poor's 500-stock index recently trading at only 14 times estimated 2008 EPS, several quarters of anemic gross domestic product and EPS growth are already priced in to the equity market.
Given that we expect the U.S. economy to avoid a prolonged recession, with corporate EPS continuing to rise, albeit at a slower pace than many assume, we think recent lows in the 1400 area on the S&P 500 will hold.
In addition to the fundamental factors we've listed, Mark Arbeter, S&P's chief technical strategist, believes the 1400 level represents key long-term technical trendline support dating back to the 2002 bear market, as well as a critical chart support from the August lows. Pervasively negative sentiment indicators are another sign that the market may hold this level, in our view.
Not surprisingly, at the sector level, Financials and Consumer Discretionary have borne the brunt of the selling and are now the only two sectors posting negative year-to-date returns. We continue to recommend that investors underweight both in their portfolios.
How do other key sectors stack up for 2008? This series of reports examines the outlooks for five S&P sectors: the four with marketweight recommendations that have the largest market cap weightings in the S&P 500—and the one sector with an overweight recommendation. A selection of five of S&P's top-ranked stocks in each sector will also be featured.