"...For the first time in 35 years, I have gotten frightened. ... I think the legislation that has been passed is going to allow everybody to take a very deep breadth and say, ok, we'll get through this. Are we going to be fine in a year from now? Oh of course; but getting through it til next Tuesday, whole 'nother question."

—Dennis Gartman, CNBC interview; 10/3/08

I. Recent Events

• The recent turmoil in the financial markets has made many investors—both professional and nonprofessional alike—frightened. And who can blame one for having the feeling of despair with the S&P 500 skidding to a fresh four-year low, economic data contracting, previous stalwart institutions dropping like flies, and credit conditions remaining extremely tight. Uncertainty breeds fear, and there remain plenty of unknowns facing the economy.
• Moreover, the passage of the rescue bill on Friday was greeted with an unenthusiastic reversal in the stock market. (From the day's high the S&P 500 retreated 4.7%.) Our sense was and continues to be that this plan—which calls for the Treasury to use up to $700 billion to purchase toxic debt from financial institutions—was a necessary step, but certainly not a cure-all. SunTrust Economist Gregory Miller recently articulated his view through the following statement: "The truth is the TARP is an awesomely awful policy. I know no economist who doesn't hate this bill. But, under contemporary circumstances there is only one thing worse than passage, and that is doing nothing."
• Although there remain questions about the mechanics of the program, the hoped-for outcome of this plan is it will allow banks that participate to sell their worst assets (which currently don't have a market) to the government, which in turn would provide much needed cash flow to the banking system, which subsequently would allow banks to start lending more freely. Most reports speculate it will be at least a few weeks before the government starts buying assets, and then it will take time to judge the effectiveness of the plan. Added attention should be paid to the credit markets, to see if spreads/lending rates start to loosen. In the meantime, investor attention will start to focus back on a weakening economy and earnings outlook.

II. Economy

• In our view, part of the reason the market did not have a more positive reaction to the passage of the rescue package is investor attention is already shifting to the deteriorating economic landscape: Last week, initial jobless claims jumped to 497K, the monthly payroll report showed a loss of 159K jobs (the ninth consecutive monthly decline), and the ISM manufacturing report dropped over six points to 43.5.

With that said, the word depression, unfortunately, is coming back into vogue (as shown in Figure 1).

Figure 1. Google Key Word Search And News Reference For 'Depression'

Source: Google

• For most of the past year, SunTrust's Economist Gregory Miller has believed the U.S. economy is in a recession that started sometime late last year and will probably end in April or May of next year; a view he continues to hold. It is evident that the economy is deteriorating, but it is important to distinguish some important differences between now and the Great Depression. While there remains some debate about the cause of the Great Depression, many experts blame it partially on Fed policy mistakes, such as raising interest rates and contraction in money supply, which is not occurring today.
• Also, in remarks made during a speech to Washington and Lee University in 2004, then Fed Governor Ben Bernanke pointed out that, "In particular, the experience of the Depression helped forge a consensus that the government bears the important responsibility of trying to stabilize the economy and the financial system, as well as of assisting people affected by economic downturns. Dozens of our most important government agencies and programs, ranging from social security (to assist the elderly and disabled) to federal deposit insurance (to eliminate banking panics) to the Securities and Exchange Commission (to regulate financial activities) were created in the 1930s, each a legacy of the Depression." Unemployment insurance is another important automatic stabilizer, which was not around during the Depression.
• Moreover, Briefing.com's Patrick O'Hare helps to place the current situation in context: "Clearly, the economic situation isn't great, but keep these statistics in mind: during the Great Depression, GDP fell 30%, unemployment exceeded 20%, wholesale prices declined 33% and industrial production plummeted close to 50%. The latest complete information available showed real GDP up 2.8% on an annualized basis in the second quarter, the unemployment rate at 6.1%, wholesale prices up 9.6% from 12 months ago, and industrial production down just 1.5% from 12 months ago."

• Moreover, it's worth remembering the stock market tends to bottom well before a recession is over, as shown in Figure 2.

Figure 2. S&P 500 Performance During Recessions (1945-2007)

Source: Bespoke Investment Group

• Likewise, historically the unemployment rate tends to continue increasing well after equities have already bottomed (see Figure 3).

Figure 3. Stocks Tend To Bottom Well Before The Unemployment Rate Peaks

Gray shading represents recessions

Source: StockVal, SunTrust Robinson Humphrey

III. Earnings

• The unofficial kickoff to 3Q08 earnings season begins on Tuesday. According to Thomson Reuters, the Street is expecting S&P 500 earnings to be down 4.8%. As shown in Figure 4, a significant portion of the decline can be attributed to write-offs in the financial sector. However, due to the slowing world economy and stronger U.S. dollar, we are starting to see estimates revised down across all ten S&P sectors (see two right-most columns in table), especially in some of the more globally exposed sectors areas, such as Energy, Materials, and Industrials.

Figure 4. Q3 S&P Sector Earning Estimates Are Being Revised Lower

Source: Thomson Baseline, SunTrust Robinson Humphrey

• Notably, both reported and operating earnings growth for the S&P 500 have already come down quite a bit from recent peaks, which is part of the sequencing process that typically occurs around recessions (see Figure 5).

Figure 5. S&P 500 Earnings Have Already Been Coming

Gray shading represents recessions

Source: StockVal, SunTrust Robinson Humphrey

• Similar to economic data, the decline in earnings around recessions typically lasts longer than the decline in stock prices. As shown in Figure 6, historically earnings on the S&P 500 have continued to fall, on average, five to six months after stocks have already bottomed (source: Factset). This implies that P/E ratios tend to increase at a market low as the stock market anticipates an economic and earnings recovery.

Figure 6. Stocks Typically Trough Well Before Earnings

Source: Factset, SunTrust Robinson Humphrey

IV. Technical/Quantitative Data

• From a technical perspective, last week we discussed the 1078-1089 area as potential support for the S&P 500, which approximates a 62% retracement of the 2002-2007 bull market and also the average decline during a bear market. Thereafter, the next significant level we see comes into play around 1060, which is around the August 2004 lows.

So How Painful Has This Decline Been?

• The average stock currently in the S&P 500 is down 38% (index is down less because of its market cap weighting) from its 52-week high and roughly 83% of stocks in the index are down at least 20%. Similarly, over 80% of the S&P subindustry groups are in a bear market. Is there any silver lining in all of this? Perhaps: an astute contact that we recently spoke with who tracks this data, states this is the greatest percentage of groups in a bear market since the market low in July of 2002. Typically in the latter stages of a bear market, there is almost no place to hide as even the prior strong segments succumb to indiscriminate selling pressure. What's also difficult is often the last leg down is the harshest as panic selling sets in (much like in July 2002), which flushes the majority of investors out, and in the process sets the stage for a more lasting recovery.

Food For Thought

• The following statement and chart is from a recent Forbes article: "American households have $7.4 trillion in checking, savings and other bank accounts and money market funds. They have another $4.1 trillion stashed in Treasuries and other bonds. That $11.5 trillion, up from $8.9 trillion (in constant dollars) in 2000, is nearly enough to buy every company in the Wilshire 5000. It's more than enough to pay off every home mortgage."

Source: Federal Reserve, Forbes

• If the Fed cuts interest rates again (as the market currently anticipates), some clients will be earning even less than the already low rates in cash instruments, such as money markets, and Treasuries. HOW LONG WILL THEY STAY THERE? While a high level of cash doesn't provide much of a short-term buy signal, it does indicate that once a fire is lit, there is plenty of fuel to keep it going.

Important Upcoming Reports

The unofficial kickoff to earnings season begins on Tuesday. In addition, Federal Chairman Ben Bernanke will speak to the National Association for Business Economics on Tuesday, and a number of Fed presidents will be speaking at various events.

V. Bottom Line

In the spirit of Dennis Gartman, we don't necessarily know where the market will be tomorrow or next week, but we do believe we'll get through this. Credit markets will take time to thaw, but we view the passage of the recent rescue bill as an incremental positive and we continue to monitor the credit markets for any signs of improvement in lending rates. Investor attention appears to have already shifted to the weakening global economy and earnings estimates that still appear too high. Yet, as we go through this process, where the economy is slowing, earnings are deteriorating, and unemployment is rising, it is important to note that these events, while painful, are normal parts of any business cycle; moreover, the stock market, as a leading barometer, tends to bottom well before improvement is witnessed in most of these indicators.

Many of the ingredients that are typically seen closer to shorter-term market bottoms are already in place, such as indiscriminate selling, dire investment sentiment, oversold conditions, high volatility levels, and a stampede into less risky assets, such as Treasuries and cash. Admittedly, it is difficult to determine what the near-term catalyst will be to help shore investors confidence enough to make them want to buy stocks (it almost always is). Perhaps it could be improvement in the credit markets, a coordinated global easing by monetary banks, or an earnings season which isn't as bad as current expectations.

As a colleague recently stated to us, this is one of the few businesses that when something goes up, people want more of it, and when it goes down, people want less of it. It's the opposite of what we are taught in Economics 101. Nevertheless, it is important to realize that cycles do eventually pass and by acknowledging the economy is probably already in a recession, the employment outlook is likely to see more deterioration, and the earnings picture should witness further deterioration, it helps to bring down expectations to a point where a little bit of good news could go a long way.

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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SunTrust Robinson Humphrey assigns one of three ratings to stocks covered by our Research Department: Buy, Neutral, Reduce.

In addition, we assign a risk rank to each stock based on a combination of fundamental and stock volatility factors: Low = Low stock price volatility reflected by high predictability of financial results. Moderate = Moderate stock price volatility reflected by medium predictability of financial results. High = High stock price volatility reflected by inconsistent predictability of financial results. Speculative = Greatest stock price volatility reflected by low predictability of financial results. Venture = Recommended only for maximum risk oriented and well-diversified portfolios.

Our ratings are a function of the risk ranking (higher return expectations for higher risk) and the absolute expected total return (price appreciation plus dividends) that result in our estimated 12-month price target. Please refer to the grid below for additional detail.

Deviations from expected price ranges/targets due to price movement and/or volatility will be reviewed by the analyst and research management on a timely basis. Price targets are only required on Buy rated stocks; The analyst may choose to have price targets on Neutral or Reduce rated stocks, but it is not required. Action taken by an investor should be based upon their personal investment objectives and risk tolerance compared to a stock's expected performance and risk ranking.

Estimate Bias: While current annual estimates are our best judgment at this time, we assign an "Up", "Neutral" or "Down" bias based on our expectation for fundamental changes over the next 12 months.

*Percentage of Investment Banking clients in Coverage Universe by rating

Other Disclosures

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.

SunTrust Robinson Humphrey, Inc. is a registered broker-dealer. It is owned by SunTrust Banks, Inc. ("SunTrust") and affiliated with SunTrust Investment Services, Inc. Despite this affiliation, securities recommended, offered, sold by, or held at SunTrust Robinson Humphrey, Inc. and at SunTrust Investment Services, Inc. (i) are not insured by the Federal Deposit Insurance Corporation; (ii) are not deposits or other obligations of any insured depository institution (including SunTrust); and (iii) are subject to investment risks, including the possible loss of the principal amount invested. SunTrust may have a lending relationship with companies mentioned herein.

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