EQ: The downgrade of the U.S. credit rating sparked a week of volatile trading in the market. What are your thoughts on how the market reacted to the news?
Stovall: In terms of equity prices, it actually responded pretty much as we had anticipated. Most people reacted negatively because of the fear of the unknown and the uncertainty surrounding the repercussions of the debt downgrade. What was interesting, however, was that equity prices went down as expected, but Treasury prices went up. In hindsight, we understand that it’s because investors were looking for a safe haven in case the U.S. and the rest of the world slipped back into a recession. So investors were more interested in capital preservation than worrying about a debt downgrade of what is still regarded as the safest bond market on earth.
EQ: You were quoted as saying that a debt downgrade could possibly lead to a recession, but ultimately didn’t think the U.S. would fall into one. Some market commentators are saying that this could be damaging to the economy’s recovery, while others have tried to downplay the impact. How do you think the downgrade will affect the economy and your target for S&P 500?
Stovall: I don’t think the downgrade itself will translate into a recession. One reason is because we did not end up seeing the spike in yields and investors running away from Treasuries after the downgrade. If yields had ticked up, there would be an increase in borrowing costs for consumers and businesses, adding to the slowdown of U.S. output. A yield spike is now off the table, but I still believe that a recession is an increasing possibility. Most economists on Wall Street believe that the likelihood of recession are between 35 percent to 50 percent. Nobody can really say for sure what is the better number, but there’s a real possibility of recession out there, particularly when you look at the most recent GDP data, and other factors like the Institute for Supply Management and the Purchasing Manager Index around the world. Basically, they’re all pointing to at least a slowdown. People are worried that this could become a self-fulfilling prophecy in which the headlines continue to blast the worry of recession, and that adversely affects consumer confidence to the point where it becomes reality.
EQ: You said in your latest Sector Watch report that you expect elevated volatility in the market to stay as the S&P 500 could be entering a new bear market. Can you talk more about that?
Stovall: Since 1950, we have had an average of five times per year in which the S&P 500 has declined by 2 percent or more in a single day. In the decade of 2000 through 2009, basically we were running at a 3-to-1 rate on average. So far, in just the year and a half of this decade, we’re running at a 2-to-1 level on an annualized basis over a longer-term average. Volatility certainly is higher. When people say that volatility has reduced because of high-frequency trading, hedge funds, leveraged ETFs, and so on, I don’t believe it because I actually see the reverse to be true. Volatility has increased during that era when these trading techniques became more prominent.
Also, I monitor on a rolling two-month basis (42 trading days), the average percent change between high and low on a daily basis averaged over that period. I chose a two-month period, rather than something shorter, as I don’t want to be looking at an EKG diagram; I want to be looking at a graph that actually shows me spikes in volatility. What I found is that every market since 1968 has ended by peaking its head above two standard deviations from the mean–except for the bear market of 1990. But every other bear market peaked well above two standard deviations from the mean. Right now, we are less than one standard deviation from the mean, which is even lower than during last summer’s decline. I definitely believe that volatility will likely rise the further we remain in a corrective mode or even possibly falling into a new bear market.
EQ: What are some reasons for optimism that investors can look to on a longer-term horizon?
Stovall: First of all, the one-week decline of 7.2 percent in the week ending August 5th was a relatively unique situation. It is only the 40th time since 1950 that that has happened. In the 39 other times, the market was higher by 18.5 percent 12 months later. The reason being that during extreme levels of price declines, you’re shaking off a lot of the nervous hands. As a result, if everyone’s being bearish, then who’s left to sell? So an extreme price decline in a single week is usually a good contrary indicator for the longer term.
Secondly, because prices dropped close to 18 percent in a very short period of time, valuations have become very attractive whether you look to the last 22 years or look back to 1936. The P/E right now on trailing 12-month operating earnings is at more than a 30-percent discount to the median P/E since 1988 when Wall Street started looking at operating results. Some people don’t like using operating earnings because they think they are really just earnings before the bad stuff. So looking at GAAP results, we’re trading at a 12.5 percent discount to the median P/E since 1936. From that perspective, you can say stocks are certainly not expensive and, as a result of the most recent decline, are attractive longer term.
Lastly, on August 12, the University of Michigan published its consumer survey and that number came in below 55. Since the survey was first started, there have only been 10 times in which the reading was below 60. Of those 10 times, eight saw the market end up higher by an average of 21 percent 12 months after. Obviously, past performance is no guarantee of future results. But, I believe that history can still offer a little optimism during a very trying time.