"...What's happening out there? It's very clear to me-we're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down."

—Morgan Stanley CEO John Mack, 9/17/08

I. Recent News

• Equity markets continued their recent slide, as investors appeared unimpressed by the government's rescue of American International Group, credit markets tightened, a large money market fund broke below the standard $1 per share, and investors wondered what company would be the next victim of the financial fallout.
• As a result, the S&P 500 fell 4.7% yesterday, and is now down 26% from its October peak, around the average seen in economic contractions since 1945, yet still below the typical bear market retracement of 30.4%. At the same time, investors fled to the safety of Treasury backed assets; and during the trading day, the yield on one-month T-Bills dropped below zero (meaning investors were basically locking in a loss) and Gold rose close to 11%, its largest gain since 1982, according to Bloomberg.
• In a response to the dislocations in the credit markets, central banks around the world -- including the Federal Reserve, the European Central Bank, the Bank of England, and the Swiss National Bank -- announced a coordinated plan to pump in $180 billion into global markets with the goal of improving liquidity. Credit markets have been very tight recently as banks have been reluctant to lend because of the fear of further financial failures.
• Understandably, investor confidence has been rattled, as the financial markets face extraordinary challenges and it remains unclear how long it will take for the current deleveraging phase to unwind. Nevertheless, as some financial entities are supported by government, some fail, and others are combined, the market becomes a step closer to removing some of the remaining uncertainties, which should eventually lead to the healing process, though admittedly it's a painful road and the duration and depth of the journey is unknown. To this point, after yesterday's close, the Wall Street Journal reported that Morgan Stanley was in preliminary merger talks with Wachovia and, separately, Washington Mutual was setting itself up for a possible sale.
• Also, last night the Securities and Exchange Commission's Chairman was reportedly seeking a proposal that would require larger investors, including hedge funds, to start disclosing short positions on a daily basis. If enacted, it could potentially discourage some short sellers, because everyone could see what they were doing, and their positions could be more apt to cause a short squeeze (this occurs when short sellers start to feel pressure from a rising stock, which causes increasing losses as the stock price moves higher.)

II. Longer-Term Perspective

• Amid the uncertainty, one thing to remember is that over longer-term periods, equities generally track earnings growth and not all companies are going out of business (even though it may feel that way). Over roughly the last 40 years, the S&P 500 has had an annual price appreciation of 6.2%, which corresponds rather closely to its growth in earnings per share as shown in Figure 1. Once dividends are included, the total return is increased.

Figure 1: A Long-term Perspective of the S&P 500 and Earnings

Source: StockVal

• Moreover, studies have shown that it is very difficult for most investors to time when to get in and out of the market: the average equity investors' annualized return between 1986 and 2005 was 3.9%, while the Standard & Poor's return was 11.9%, according to Lewis Harvey of Boston-based investment-research firm Dalbar. In many instances, by the time investors decide to sell, prices have already fallen; similarly, when investors feel comfortable to get back in, chances are they are comforted by gains in stock prices (the process also requires an investor to be right twice).
• Next, Figure 2 illustrates the findings of a Schwab study that looked at different holding periods for the S&P 500 from 1926-2007. Its research shows the longer an investor's time horizon, the less likely they are to incur a loss. For example, the greatest one-year calendar decline for the S&P 500 was 43.3%; however, over a 5­year period, the greatest downside witnessed was considerably less at -12.5%.

Figure2: Longer Holding Periods, Historically Have Led to Lower Risk (S&P 500 Returns)

Source: Schwab Center for Financial Research with data provided by Standard and Poor's. Every 1-, 3-, 5-, 10-, and 20-year rolling calendar period for the S&P 500 Index was analyzed from 1926 through 2007. The highest and lowest annual total returns for the specified rolling time periods were chosen to depict the volatility of the market. Returns include reinvestment of dividends. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

• Moreover, a separate FMRCo (MARE) study found when the trailing 10-year returns for the S&P 500 have been poor, as has been the case recently, it has generally been followed by better future performance.

Figure 3: Weak Trailing 10-Year S&P 500 Performance Periods Have Typically Led to Better Forward Returns

III. A Look at Investor Sentiment

• At times like this, we often pay closer attention to a number of sentiment indicators to help us better understand how investors are reacting to market dislocations. Sentiment indicators are normally used as contrarian tools and help to gauge market extremes: market tops often occur when most of the crowd is bullish, while market bottoms tend to form after excessive levels of pessimism. The thinking goes, if the majority of investor are bullish, then they have most likely already positioned themselves accordingly by buying stock (so who's the marginal buyer?); conversely, when investors are very negative, many of them would have already sold stock and have cash on the sidelines, so if they get incrementally more positive, this represents potential buying demand that could support stocks.
• The chart in Figure 4 overlays the S&P 500 with the 10-day CBOE Put/Call ratio. Much like insurance, investors buy puts to protect the downside of a position or to express a negative opinion. Often closer to market bottoms, there will be a spike higher in this indicator as investors get nervous and look to protect themselves, but high levels of buying of these instruments often occur at the later stages of a market decline. The current reading of 0.89 compares to the average reading of 0.59 since 1997. This is one of the highest readings over the past decade, with other extremes recorded after the September 11 attacks, around the February/March 2003 lows, and more recently in March of this year. Incrementally we see this as a positive sign, but the data set is somewhat limited.

Figure 4: Equity Put/Call Ratios Moving Toward an Extreme Level

Source: Bloomberg, SunTrust Robinson Humphrey

Figure 5: VIX Increases to 2008, but Still Well Below 90s/early 2000 Levels

Source: SunTrust Robinson Humphrey, Thomson One

• Next, as we have shared in the past, volume surges over the past year have often been associated with shorter-term lows. Over the past few days, we have witnessed record levels of NYSE Composite trading (see Figure 6).

Figure 6: Volume Surges Have Been Associated with Prior Short-Term Lows

Source: Thomson One, SunTrust Robinson Humphrey

• Also, as illustrated in the bottom panel of Figure 7, the percentage of stocks in the S&P 500 above their 50-day moving average has been declining, but not yet at the sub-20% level generally considered oversold.

Figure 7: Percentage of Stocks above 50-Day Moving Toward Oversold, but Not Quite There

Sources: Stockcharts.com

• All in all, the sentiment indicators reviewed appear to be moving in the right direction, but it remains premature to say any type of sustainable bottom is set. Moreover, after the extreme selling pressure of late, it will be important to see some strong buying pressure on any rally, much like we saw initially off the March lows.

IV. Bottom Line

Equity markets are facing unprecedented challenges, and the current period is filled with vast uncertainties, which continues to pose near-term downside risk. Each investor has a different set of circumstances, risk tolerance and timeframe. Often, when asset allocations are set in bull markets, it's easy for an investor to overestimate their tolerance for risk. If on a personal level, the current market stress test is proving too much, then it may be prudent to reduce one's equity exposure. Obviously, an individual that has a two-year investment horizon is not afforded the same time benefit to ride out a downturn that a person who has a five- or ten-year outlook. While we don't pretend to have all the answers, we continue to believe equities are one of the best ways for investors to generate wealth over the long-term. We would also caution clients not to let panic/emotion dictate a well thought out investment plan, as studies have shown it is very difficult to time when to get in and out of the market (which also requires an investor to make at least two great calls), and extreme levels of pessimism are typically prevalent at market lows.

Analyst Certification

I, Keith Lerner, CFA, CMT, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject company(ies) and its (their) securities. I also certify that I have not been, am not, and will not be receiving direct or indirect compensation in exchange for expressing the specific recommendation(s) in this report.

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*Percentage of Investment Banking clients in Coverage Universe by rating

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Information contained herein has been derived from sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be a complete analysis of the security, company or industry involved. This report is not to be construed as an offer to sell or a solicitation of an offer to buy any security. SunTrust Robinson Humphrey, Inc. and/or its officers or employees may have positions in any securities, options, rights or warrants. The firm and/or associated persons may sell to or buy from customers on a principal basis. Investors may be prohibited in certain states from purchasing some over-the-counter securities mentioned herein. Opinions expressed are subject to change without notice. The information herein is for persons residing in the United States only and is not intended for any person in any other jurisdiction.

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Keith Lerner, CFA, CMT, is the chief market strategist with SunTrust Robinson Humphrey.