As Sam Sees It: "Baby Bear" Could Be Just Right for Bulls

Sam Stovall |

Sam Stovall talks to Equities.comEach week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

EQ: In your most recent Sector Watch report, you focus on what's called "baby bear markets." What are these and are they as adorable as they sound?

Stovall: Well, I guess no bear market is adorable but a baby bear market is a little softer on one's portfolio than, say, if it had been a "Papa bear" market. What I mean by baby bears and near-misses are those market declines on the high-end of between 15 percent to 20 percent--which are called severe corrections--and just below the bear-market threshold of 20 percent. So if the S&P 500 has likely put in its low for this correction, which we did on Oct. 3 at the 1099 level, then we fell from peak-to-trough of 19.4 percent. This does not classify it as a bear market but certainly does as a severe correction. There have been eight times since World War II that we had either a severe correction or a baby bear market, and I wanted to see what kind of performances the S&P 500 exhibited in three, six, and 12 months after these baby bears or near-misses had run their course.

What I found was that in each occasion, the market was higher three, six, and 12 months after these corrections. The S&P 500 gained an average of 13.5 percent three months after the conclusion of these declines, 23.1 percent after six months, and 31.7 percent after 12 months. Of course, past performance is no guarantee of future results.

EQ: Assuming that this correction bottomed in early October from the April 29th high--and there's no guarantee that it did--you place the break-even point for the recovery somewhere between November and January. How did you come up with this timeline?

Stovall: There have been 18 corrections since World War II, and on average, they have taken about two to four months to materialize, and then another two to four months to get back to break-even. The reason why I say "two to four" is because it depends on whether you use a mean or median average. The median time has been two months to get back to break-even, whereas the mean has been four months.

Last summer, in 2010 when the S&P 500 lost 16 percent, it took us exactly four months to get back to break-even by Nov. 4, 2010. So this time around, I'm simply quoting the averages, and if we have bottomed on Oct. 3, then it could be anywhere between the end of November and early December for the median, and January or early February for the mean before we get back to break even. Again, remember that history is a guide but never gospel.

EQ: On that note, history shows that the most distressed sectors during a correction tend to be the best performers during recovery periods. Which sectors could potentially lead the market higher?

Stovall: It makes sense because those companies, industries, and sectors that were priced to go out of business but did not, are therefore the ones that have the greatest upside potential. People were just willing to just throw them away without regard to valuation. It's usually the cyclical sectors like Technology, Consumer Discretionary, and Industrials that get beaten up the most. The more defensive areas like Consumer Staples and Utilities end up retaining their price levels more so during bear markets. Therefore, when the bear market or the severe correction has run its course, then things get turned on their ear and the cyclical sectors that were beaten up the most tend to be the leaders, whereas the defensive sectors that maintained their capital much more so during the bear markets tend to be the laggards in pending recoveries.

If we use history as a guide, we would see that Information Technology and Consumer Discretionary--both sectors that S&P currently has Overweight recommendations on--as well as Industrials and Materials would be among the better performers. What's also interesting is that a rising tide lifts all boats, and that all 10 sectors in the S&P 500 posted average increases in the six months following the end of these market declines. But of course, there's no guarantee that what worked in the past will work again in the future.

EQ: Financial stocks have been the hardest hit during this downturn. Is it possible that they could lead the recovery?

Stovall: Financials, interestingly enough, were among the six best performing sectors coming out of market declines in terms of average price change, but their frequency of beating the market was only 40 percent, so sometimes they did, but most times they did not. That's only because there were a couple of times where we had very strong price appreciation that allowed Financials to end up with an average price change that was in excess of the markets. I still believe that with an awful lot of headline risk emerging from Europe, that it could possibly continue to put pressure on Financials. So we're not willing to take an aggressive position with Financials currently.

EQ: For the near-term, as investors are watching the market trying to work its way higher, are there any economic factors that you think they should watch more closely?

Stovall: I think the cause for the recent market decline has been three-fold:

  1. China: The fear of a hard landing in China rather than the government being able to engineer more of a soft landing--meaning a reduction in economic growth rather than an overall decline.
  2. U.S. Recession: Investors have also been worried that the U.S. would slip back into recession and that corporate earnings growth would be cut dramatically.
  3. Europe Debt Crisis: Finally, investors are very, very worried about the lingering sovereign debt woes that are recurring in Europe.

From the perspective of China, our belief is that they will probably be able to engineer a soft landing and not have a hard landing, but investors should continue to monitor their Purchasing Manager Index [PMI], industrial production, and retail sales information to see if indeed a soft landing is likely to be engineered.

For the U.S., I would say look to the same economic data points that will help to signal that we are still in a half-speed recovery, but will not likely fall into recession. Also, watch earnings growth prospects because typically in recessions S&P 500 earnings tend to fall an average of 18 percent. If we start to see a whittling down of earnings growth expectations, then that could also be a sign of an impending recession.

But the real wild card out there is Europe. I don't think that there's very much we can do other than just pay attention to the news items and hope and believe that the leaders of Europe want the same things that the equity markets do, which is a resolution to this Greek default crisis. If a resolution is not developed and implemented, then there could be a contagion of concerns that would spread to larger economies such as Spain and Italy.

EQ: What about from a technical standpoint? Are there any indicators like moving averages or key levels that they should pay attention to?

Stovall: Certainly watch for the market if it approaches the 1099 level on the S&P 500, which was the bottom on Oct. 3. We think that level will hold as the bottom for this correction. There are other levels that investors can look at even before we get to the 1099 level, which would be the 1175 level because those are important retracement levels found in the S&P 500. In general, look to see if the double bottom is actually going to hold, and if so, then we could actually see the market start slowly working its way higher and provide us with a nice end of year rally.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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