Correction to Bear Market?  What are the risk factors?

As of last week, the US stock market is officially in correction (defined as a decline off 10% or more from a previous peak.  This table shows the extent of the decline by sector

Sector	Decline from 2007 peak
CONS DISCRET	-25.708%
CONS STAPLES	-4.590%
ENERGY	-6.912%
FINANCIALS	-28.717%
HEALTH CARE	-2.712%
INDUSTRIALS	-13.766%
INFO TECH	-14.777%
MATERIALS	-7.170%
TELECOM SERV	-13.686%
UTILITIES	-2.001%
S&P 500 INDEX	-11.359%

with Consumer Discretionary (Housing, automobiles) and Financials already in bear market territory (defined as a decline of 20% or more from the previous peak.)  As this is the 4^th significant downdraft in stocks in the last 12 months (also February, August and November), investors are feeling particularly skittish.  

Financial service stocks, which peaked in February 2007, accelerated sharply downward in October 2007 as the major banks, starting with Citigroup, announced unprecedented losses on investments in Collaterized Debt Obligations (CDO's).  Citigroup announced $6.5 billion in losses in October and projected losses of $11 billion in November.  Brokerage house estimates of Citigroup's losses rose steadily over the last two months. 

As Citigroup is one of the biggest losers in the CDO meltdown, we've been waiting with trepidation for today's earnings report. Citigroup's reported write-off was $18 billion on CDO's and another $4 billion on related credit instruments.  Earnings slid 78% to $0.91/share, less than half of estimates, so a pretty disastrous report.  The dividend, as expected, was cut 41%, although the current yield of 4.77% remains one of the highest in the S&P 500.  There is the perception that the new management team, in place for only 5 weeks, wanted to stuff as many problems into the current report as possible, setting the stage for upside surprises later this year.  After the previous earnings report, Citigroup stock declined 31% in a day.  Although today's news is much worse, the stock is down 7.3%, touching a level not seen since July 2002.  Although Citigroup received a host of down-grades today, we actually think that the stock will be higher 6 months from now.

Slow Down or Recession?

The most recent Bloomberg poll of 62 economists shows 40% projecting a recession in 2008 (defined as two quarters of negative growth.)  The average growth forecast for the first half of 2008 is 1.5%, and the current forecast for 4Q GDP growth, due to be announced January 30^th, is also 1.5% (the previous quarter's final number was 4.91%)  As we mentioned previously, housing prices look to slide another 7-10% in 2008, possibly continuing to slide in 2009, which would lower GDP growth in the US down by 1-1.5%/year, so our forecast is consistent with the consensus.  The unemployment rate currently stands at 5%, the highest level since November 2005, but also matching the average of the current decade (unemployment averaged 5.8% in the 1990's and 7.3% in the 1980's), so not too bad (the peak level of this decade is 5.5%.)

According to Zacks Investment Research, 4th quarter earnings growth looks horrible (down 8.3%), but strip out Financials, which are estimated to shrink earnings by 61.8%, and earnings still may grow 11.5%.  Telecom and Technology companies are expected to deliver plus 20% earnings growth in Q4, and decent growth in 2008.  Furthermore, earnings for the Financials are projected to rebound substantially later in 2008, assuming that we're past the bulk of the write-downs.

The stock market, appears to have fully discounted a recession in 2008, not only corrected 11.4% from the October 9^th high, but also running several percent below the level of a year ago, which historically has been the predictor of "9 of the last 5 recessions." 

Hold stocks, buy or sell?

We've been fielding calls from concerned clients all month.  The current correction is the third of the last 12 months, the daily volatility is huge, and the whipsaws are exhausting.  The natural instinct is to just bail out.

Last week's American Association of Individual Investors (AAII) survey showed 59% of their readers bearish over the next 6 months, only 20% bullish, with the 39% gap between bulls and bears the worst result in 17 years.  In fact, this survey is a famous contrarian indicator at the extremes.  There have only been three other occasions (October 1992- tail end of last real estate slowdown, S&L crisis, junk bond melt down; February 2003 - tail end of tech wreck bubble and aftermath of 9/11 attacks; July 2006 - Israel/Lebanon war) when bears exceeded bulls by more than 30%, and on those occasions stocks rose 14%, 35% and 24% respectively over the next 12 months.  This indicator suggests that now would not be a good time to sell stocks

The Fed has worried more about inflation than a growth slow-down over the past year and has lowered rates only grudgingly.  However, continued falling home prices will definitely be deflationary in 2008.  Also, energy prices, which nearly doubled from $55 to $100 in 2007, are unlikely to double to $200 in 2008 (and in fact have eased 9% to $91.17).  Gold prices, a traditional harbinger of inflation, soared 39% from August 2007 to a recent high of $904.  However, we think that rally is tied more to cash flowing into that market rather than any fundamental factors (demand didn't jump 39% over the past 6 months, nor did the dollar fall 39%). 

The other risk of inflation comes from the dollar, which has gained 6.7% against the British pound in the last two months, but remains worrisomely close to an all-time low against the Euro and a 15 year low against the Japanese yen.  A rising dollar would pull in cash from non-US investors, while keeping the cost of imports from rising (and would put additional downward pressure on energy and other commodity prices.)  The Fed is certain to cut rates by 25 BP to 4% on January 31^st, possibly even 50 BP to 3.75%.  The current forecast is for rates to be as low as 3% by September.  Previous Fed cuts delivered little benefit as LIBOR rates, (the rate which banks lend amongst themselves and which normally track Fed Funds closely) actually rose in December.  However, that gap has closed, which itself is a bullish development.

Generally speaking the best time to buy stocks is when the Fed is cutting rates, because the fair value of the stock market is very sensitive to interest rates.  If we take Zacks's estimate of 15% earnings growth in 2008 and assume a 4% yield on the 10 year treasury (vs. the current 3.7%) we obtain the S&P 500 undervalued by 42%.  If we slash the earnings growth in half, the S&P 500 is still undervalued by 32%.  Earnings would have to fall by 16% (not impossible, but not likely) over the next year for the stock market to be fairly valued at current levels.

Strategy

Bottom line: the stock market action of the last 3 weeks looks like a selling climax, with many more stocks trading down than up, with the volume predominantly negative, and with extremely bearish investor sentiment. 

Moments ago, Intel released their earnings report - Record revenues of $10.7 billion, net income up 51% to $2.3 billion, earnings per share up 46% to 38 cents a share.  However, the consensus analyst estimate was for 40 cents a share, so the stock rocketed down 13% in after hours trading - that's just ridiculous.

Historically, situations like this are opportunities to buy stocks.  We're gritting our teeth, not selling stocks and looking to deploy cash at the first opportunity.