BUSINESSWEEK - Market Views July 31, 2008, 12:01AM EST

With market psychology so negative, it’s easier for positive developments—like falling oil prices— to lift investors’ spirits

by Alec Young From Standard & Poor’s Equity Research

After coming in like a lion, July went out like a lamb. The beauty of a bear market is that investor psychology gets so negative, and forward-looking assumptions become so dire, that it’s easier for future events to exceed investors’ lowered expectations.

The price of crude oil is a case in point. Its 17% retreat since peaking on July 11 has been a welcome reprieve, given that the market sell-off from June through early July was, in our view, predicated in part on soaring energy prices. In addition, while second-quarter earnings per share for companies in the Standard & Poor’s 500-stock index were down 19% year-over-year (through July 22), we believe many investors had been bracing for worse.

While these positives have helped equities find a short-term floor at 1200 on the S&P 500, we think the market’s ability to remain above that level and build upward momentum will be driven by the macroeconomic outlook for the second half and its implications for corporate profits. Oil prices need to continue declining, in our view, and the housing and job markets need to show signs of stabilizing.

Choppy Markets Ahead

If these trends play out, credit markets are likelier to stabilize, improving visibility for second-half EPS. With so many wild cards still in play, we expect equity markets to remain choppy.

S&P Economics expects U.S. gross domestic product (GDP) growth to decelerate to 1.6% in 2008 amid ongoing weakness in U.S. housing, a sluggish job market, high energy prices, and tight lending standards. In addition, we believe the Fed will remain on hold through yearend as it balances the downside risks to economic growth and increasing pricing pressure.

At the sector level, we recommend overweighting the information technology, consumer staples, and materials sectors, where we believe negative EPS revisions are least likely.

Conversely, we continue to recommend underweighting areas with limited EPS visibility like consumer discretionary, financials, and industrials.

The remaining sectors—energy, health care, telecommunication services, and utilities—carry a marketweight recommendation.

Young is an equity strategist for Standard & Poor’s .

source: BusinessWeek

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