Last week, the
S&P 500 Index
dropped 6.5% to 1,136. The index gave back the 5.4% gain achieved in the prior week, the third-biggest weekly gain since 2009, which had lifted the index to the top end of the range at 1216. The volatility continues within the range of about 1120 to 1220 on the S&P 500, a range that has prevailed since early August as you can see in Chart 1.
Chart 1: S&P 500 Traverses its Range
Source: LPL Financial, Bloomberg data 9/25/11
The S&P 500 is an unmanaged index, which cannot be invested into directly. Past performance is no guarantee of future results
The declines were not restricted to the U.S. markets as the concerns remain focused on the European debt problems. Based on the
MSCI All-Country World Index
, stock markets around the world lost over $3 trillion last week (by comparison, all of Greece's government debt totals about $200 billion) and entered a bear market as fear of default among some troubled European nations increased once again. This was the third-largest weekly decline since the global recovery began in March 2009.
It is no surprise that the market appears to be demanding a policy response to the debt problems in Europe. All of the major European stock markets are in a bear market, having declined by about 30% from the peak in early May. However, many of the world's largest markets have avoided a 20% or more decline defined as a bear market, such as those of the U.S., UK, Canada, Singapore and New Zealand. The losses in Europe have been, in general, twice as large as those in non-European nations. They are more severe than even the 21% decline from the peak in Japan which suffered a devastating earthquake and tsunami earlier this year.
While stock values have been affected by the negative sentiment, analyst earnings estimates, in contrast, have remained resilient. In fact, there is not a single nation among the largest 24 whose companies are expected by analysts to produce a loss in aggregate during the coming fiscal year. For example, in the U.S., the estimated earnings growth rates for the S&P 500 for the coming four quarters are in the double-digits: 14%, 15%, 11% and 15%. Even in Europe any losses are expected to be temporary and give way to double-digit earnings growth in the coming fiscal year, as you can see in Table 1.
While U.S. stocks have fallen 15%, analysts' earnings estimates have only been trimmed by about 2%. While we continue to believe, as we have all year, that earnings estimates are a bit too high, we do not believe the major decline priced in by the market is likely. The earnings outlook remains supported by company guidance and world industrial output that remains close to all-time highs. In Europe, earnings growth also remains positive. Market participants have priced in an expectation that earnings will suffer double-digit declines as a recession and financial crisis erupts, rather than double-digit gains in the coming year as a crisis is averted.
Despite all the negative news, the S&P 500 Index has remained range bound for the past seven weeks. This is most likely due to the fact that a sharp downturn in earnings is already priced in combined with the prospect for earnings growth if a crisis is averted.
There are several ways a crisis may be averted. While eurozone members have yet to ratify the changes proposed to the European Financial Stability Facility this summer, we believe they will do so with votes scheduled in the coming weeks. Once ratified, a concern market participants have with the EFSF is its limited size of about 440 billion euros.
A plan championed by U.S. Treasury Secretary Geithner that is winning some support in Europe would allow the EFSF to borrow from the European Central Bank, multiplying the funds at its disposal and the impact it can have. The leveraged EFSF funds could be used to buy substantial amounts of troubled European nation debt, making the debt a collective obligation of the eurozone and essentially providing a bridge to eurobond issuance down the road.
This form of rescue plan also has the added benefit of acting as stimulus in the form of quantitative easing for the euro zone. These assets can also be used to recapitalize banks that may suffer losses from a partial default by Greece. This is just one of several plans being discussed in Europe to avert a crisis.
Europe's problems are manageable, but they need to be managed. The market moves seen last week pushed policymakers closer to the tough decisions needed to take decisive action and regain the confidence of investors.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.
Jeffrey is Chief Market Strategist and Executive Vice President at LPL Financial.