How to Play the Market Sell-Off
by Jeremy Siegel, Ph.D.

It doesn't take much when you're near the tipping point. Last week Countrywide Financial said it had increased defaults on some of its home equity loans and several banks took unexpected charges against potential credit defaults. Suddenly investors reacted as if the whole world had changed. Their fears sent the popular stock averages to their biggest loss in almost five years and the bears proclaimed that the days of easy credit that has fed the bull market over the past 4 ½ years were finally over.

Valuations are Sound

But the purveyors of doom and gloom are wrong. It's true that over the past few years the interest rate spreads between the high and low-rated debt became extremely low by historical standards. Then tremors developed last February when the sub-prime mortgage crisis surfaced. These tremors turned into an earthquake last week when the private equity firms and banks wanting to acquire Chrysler and Alliance Boots failed to attract the lenders needed to finance their $20 billion buyout. All of a sudden, the stock market bears emerged from hibernation to yelp "I told you so!"

But the bull market in equities did not depend on these low spreads or on the rising tide of leveraged buyouts. Despite the fizz in a few stocks, the overall level of the stock market never became overpriced relative to the most fundamental metric of firm value - corporate earnings.

Based on the S&P 500 Index, which constitutes 80% of the total market value of U.S. stocks, these stocks are now selling at 16.5 times a conservative estimate of 2007 earnings. In a world where government rates are below 5% and inflation is below 3%, stocks are not only reasonably priced, but cheap on a historical basis.

Positives for the Equity Market

But valuation is not the only reason to stay invested in stocks. The following facts are also very positive for equities:

(1) Although there was a sharp increase in the interest rate on low-grade debt securities, there was little if any increase in interest rates on investment grade securities, which constitute the vast majority stocks in S&P 500. This is because the increase in the spread between investment-grade bonds and the Treasury yields was more than offset by the drop in U.S. treasury yields, so credit costs for quality stocks have not increased.

(2) Although the housing market remains in the tank - and will stay there for quite a while - there is still no convincing evidence that the rest of the economy is headed for a significant slowdown and certainly there are no signs of a recession. Second quarter GDP grew at 3.4% rate despite a lousy housing market. Early estimates for this quarter are for 2.5% to 3% growth. This would be greater than the slow growth of the first half of the year during which time corporate earnings still rose briskly.

(3) In a worst-case scenario where the tightening of credit standards does lead to a substantial economic slowdown, the Fed has ample room to ease interest rates from the current 5.25% level. With the sharp drop in treasury yields across the board, the term structure of interest rates has once again become inverted, with the ten-year bond falling to 4.75%. This puts the central bank on alert that the market thinks that short term rates may be too high. In fact, the Federal funds futures market now expects two 25 basis point reductions in the Federal funds rate by next summer. Although I think the economy will stay strong enough so that the Fed will not have to lower rates, if the Fed does act, this will be very positive for stocks.

(4) A large part of the stock decline last week was due to portfolio managers establishing defensive positions by buying index puts to protect themselves against market declines. The VIX index, which measures the premium that investors pay for such puts reached 24, the highest level since the start of the Iraq war 4 ½ years ago. Spikes in this index have historically been great times for investors to buy stocks.

(5) It will be several months before we find out how hedge funds faired during this turmoil. If their returns suffered, this could ultimately be very good for stocks. Hundreds of billions of dollars have migrated from the equity markets to "alternative investments" in recent years. If these alternatives fail, it is very likely that much of this money will return to the equity market.

What Should Investors Do?

The strategy for investors is clear. The cost of credit has not gone up to the top credit companies - such as those rated A and B by Standard and Poor's. It is the lower-rated firms, as well as many smaller stocks that have do not have a ready access to the credit markets that will be hurt the most if spreads remain wider. Those lower rated stocks have had a wonderful ride for the last several years, but that ride is over. Quality stocks are set to outperform the market and withstand the credit storms.

Is there anything to worry about? Sure. Oil prices continue to rise in spite of the declarations of Kuwaiti officials who said they would like to see crude oil back in the $60 range. If oil and its derivatives - gasoline and heating oil - keep marching upward, this will crimp consumer spending and slow the economy.

But, history tells us that the worst time to buy is when there are no clouds on the horizon and everyone is optimistic. On the other hand, the best times for stocks are when there are mountains of worries. Despite the scary headlines, the underpinnings of our economy and stock market remain strong. Rotate to quality stocks and you will weather the storm well.