Where the Stock Market Will Find Relief

Despite the year's lousy start, S&P expects Fed rate cuts and decent corporate earnings to lend support to stocks in 2008

The U.S. equity markets had every reason to slip into bear-market mode in 2007, in our opinion. Oil prices rose nearly 60% last year, while the average home price declined for the first time since the Great Depression, slipping 6.1%, according to the Standard & Poor's/Case-Shiller Index. That contributed to tumbling consumer confidence.

Earnings growth for the Standard & Poor's 500-stock index went from a 16% advance in 2006 to a near 1% decline in 2007 (as of midyear, S&P equity analysts were still calling for a year-over-year rise of more than 7%) as a result of the cascading effects of lower home prices, the rise in subprime defaults, and the resulting megabillion-dollar writedowns from unmarketable collateralized debt obligation (CDO) investments, which triggered the as-yet-unresolved credit crunch.

Despite all of these potentially psyche-damaging factors, the S&P 500 gained 3.5% for the year, bested by the Dow Jones industrial average's rise of 6.4% and the Nasdaq composite index's jump of 8.7%. S&P's Equity Strategy group believes that has something to do with expectations toward E.I.E.I.O., or employment, inflation, earnings, interest rates, and oil.

Solid Earnings Growth

Despite the less-than-expected 18,000 increase in nonfarm payrolls announced on Jan. 4 (November's data were revised upward, however) and a rise in unemployment to near 5% (due to a sharp drop in construction jobs), S&P Economics believes the dramatic decline in home prices will not trigger a deep consumer-led recession, such as was experienced in the mid-1970s and early 1980s. We forecast job growth to hold up better than many may be expecting. In fact, S&P Economics projects payroll employment to rise to an average 139.2 million in 2008, vs. 138 million in 2007, and to hit 140.1 million in 2009.

We also don't see the gradual rise in inflation preventing the Fed from its rate-reduction efforts. We see both headline and core (excluding volatile food and energy prices) inflation rising 2.1% in 2008, with the highest year-over-year increase in the first quarter. Our belief is that the Fed is focused on averting recession, and it will live with a slight uptick in inflation for the time being.

Earnings growth expectations continue to support investors' outlooks, in our view. Despite the weekly downward adjustments to 2007 estimates, S&P equity analysts forecast a 15.7% year-over-year increase in 2008 earnings per share (EPS) for the S&P 500. Wall Street consensus estimates are not too dissimilar, according to Thompson First Call.

S&P projects the largest advances in the Telecommunications Services (+35%), Consumer Discretionary (23%), and Information Technology (+23%) sectors, while Energy (+7%), Materials (+7%), and Industrials (+10%) are likely to record the lowest EPS increases. Reasons for these strong EPS advances in the face of a possible recession include easier 2008 comparisons with dismal 2007 results, plus the eventual benefits to U.S. economic growth brought on by lower interest rates. In addition, we project international economies will continue to grow more rapidly than that of the U.S.

Oil Prices Peaking

Since the economy is projected to slow, and inflation is not likely to rise uncontrollably, we think the Fed will continue to cut short-term rates, bringing the Fed funds rate to 3.5% by this summer. What's more, we don't believe the U.S. central bank will be the only one lowering rates. We project the European Central Bank to follow the U.S. and British leads and begin lowering rates by midyear.

The wild card is oil, in our view. To the dismay and disbelief of many, prices for the benchmark grade of West Texas Intermediate (WTI) crude oil rose from an average $26 per barrel in 2002 to a shade more than $100 just a few days ago.

Of course, the natural inclination is to forecast stubbornly high oil prices for the foreseeable future. We disagree. S&P's Energy Group sees WTI oil prices averaging around $76 in 2008. In fact, our Investment Policy Committee recently stated that it believes oil prices may be near a peak, because of the large oil and gas projects beginning to come on stream, the typical seasonal slowdown in global oil demand during the second and third quarters, the projected decline in U.S. growth this year, and the impact of high oil prices on demand.

From Near Lows, Indexes Will Rise

That's not to say there won't be rough sledding over the coming months. On the contrary, even though the S&P 500 has experienced 11 one-day declines of 2% or more since Feb. 27, when we experienced our first in nearly four years, we believe more such days are quite likely. In fact, we think that with at least a 40% chance of recession, the major U.S. equity averages are likely to retest their August and November lows before moving higher later this year. According to Mark Arbeter, S&P's chief technical strategist, critical levels include 1407 for the S&P 500 and 12,743 for the Dow.

Despite the less-than-reassuring start to the new year, we believe the S&P 500 will have surprised many investors by posting a respectable advance of around 12% in 2008, and will close the year near our Investment Policy Committee's target of 1650.