Financials Aside, Stocks Aren't in Bad Shape

OK, SO IT'S NOW an "official" bear market. So what? So the S&P 500 has fallen 20% from its October 2007 all-time highs. That's what. That's all it means.

That's enough, I suppose. If you hold an S&P 500 index fund in your 401(k), then you've taken a big loss since October. Nothing I can say will make that sad fact go away. Nor the fact that I've been more or less bullish on stocks, and at the moment I'm looking pretty darn wrong.

Which brings up a very fundamental question that cuts to the heart of investment strategy: When you've been wrong, does that necessarily mean you should reverse your position? If you were wrong to be bullish, should you ipso facto turn bearish?

Of course not. Here's the fundamental principle involved: Investing is all about the future. It makes absolutely no difference whether you were wrong — or right, for that matter — in the past. All that matters is that you be right about the future, if you possibly can.

So when you've been wrong, it's very important to get over feeling awful about it and take a hard look at what's really happening.

Let's start by putting all this "official" bear market stuff in context.

Judging the stock market's losses against the all-time high value on Oct. 9, 2007 — as all the media accounts of the "official" bear market are doing — is quite unfair. By starting the performance clock at the highest point stocks have ever seen in all of history, it makes the subsequent drop as large as it can possibly be.

Also, the 20% drop you hear quoted all the time ignores dividends. Since the peak last October, you've earned about 1.5% in dividend yield if you held the S&P 500. Not a lot, I admit. But it is a plus-factor, yet you never hear it mentioned in the media.

Since October, there has been very wide dispersion of performance between different sectors in the stock market too. It's hard at this point to even talk about "the market" as though it's a single, monolithic entity.

For example, the financial sector has gotten absolutely killed since last October. Even including a little offset for dividends, the S&P 500 financial sector has dropped 44.6% since then, more than twice the drop of the entire market.

Unfortunately, financials were — I repeat "were" — the S&P 500's largest sector by market capitalization, so that big drop had a big effect on the overall index. If you take financial stocks out, the rest of the S&P 500 has only lost 12%, including dividends.

Two other sectors — out of 10 total S&P 500 sectors — have actually been winners since last October. The energy sector is up 5.7% including dividends, and the utilities sector is up 0.9%.

Another thing to bear in mind is that there's nothing magical about the "official" number of 20% in terms of guessing where stocks might go next. There's no historical reason to think that just because stocks have dropped 20% they are likely to then drop further. If anything, after stocks have taken a big drop, you'd expect them to rise because, all else equal, when their prices drop they become better bargains.

Outside the financial sector, I think stocks really are a bargain. Take the health-care sector, for example. Since October, it's down 12.2%, including dividends. So it's dropped exactly as much as the overall market, if you take away the financial sector. Yet the health-care sector's forward earnings are very nearly at all-time highs. Sounds like a bargain to me.

And how about the tech sector? It's down 16.8% since October, including dividends. But its forward earnings are now literally at all-time highs. Another bargain.

In fact, out of the 10 S&P 500 sectors, five of them — consumer staples, energy, health care, information technology and materials — are at all-time high forward earnings (or just a couple basis points away).

Financials, on the other hand, are no bargain. There was a time late last year when I had hopes that the sector could pull out of its crisis-driven nosedive. But I was wrong. Very wrong. I've since come to see that they are fundamentally broken. Even when the crisis passes (and it will) these businesses won't have any way to generate revenue growth. Remember, subprime lending was their best idea. You don't even want to hear their second-best idea.

Yet the valuations in the financial sector are no more attractive than they were a year ago when it looked like the banks and brokers ruled the world. Sure, the stock prices have cratered. But forward earnings have cratered too, but nearly the same exact amount. Thus: no bargain.

So, here we are. It's an "official" bear market. There's even a picture of a growling bear on the cover of the highly respected Barron's magazine.

Sorry if I can't slit my wrists, or whatever it is I'm supposed to do to show my respect for the conventional wisdom that the world is going to hell in a handbasket. I'm sorry if I can't instantly become an end-of-the-world pessimist like everyone else. I simply don't believe things are as bad as they look.

So my best bet for the future, at least the next couple of months, is that there probably isn't really much room on the downside at this point. At the very least, stocks are due for a very tradable upside correction. After that? Well, we'll jump off that bridge when we come to it.

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com.

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