The Scary Second Half

Second verse, same as the first?

It's been a brutal year so far, and investors are already worried that the rest of 2008 could get a good deal worse.

That's understandable, given that the third quarter started off with most indexes slumping into bear territory.

As of last week, the Dow, Nasdaq, and S&P 500 are all off at least 20 percent from highs set last October. Stocks started testing 2008 lows set back in the first quarter over the past several weeks, and they have now dropped below those levels, prompting fears that the market's next move could be down.

"I think we have a direction, and it's the one I'm not looking for," says Bill Stone, chief investment strategist for PNC Wealth Management.

In fact, among the best things we can say about markets right now is that a lot (though by no means all) of the bad news is behind us.

At times like these, when Wall Street looks its most downtrodden, some of the only arguments for higher stocks stem from the fact that bearish sentiment has turned so glaringly negative.

Two quick examples:

The closely watched AAII poll of investor sentiment showed more than 50 percent were bearish as of mid-June.

Consumer confidence measured by the Conference Board is at its fifth-lowest level ever, and its survey of future expectations argues for a further shift down.

When things get that bad, contrarians argue, the stage for a rebound is set.

Influential advisers like Charles Kirk wrote yesterday, "We are so extremely oversold at this point that the conditions are almost perfect for another large-scale countertrend rally to develop, so don't be caught off guard if we see one begin."

Bullish calls are also coming from Deutsche Bank, Lehman, and UBS, where strategists predict the S&P 500 will make back most of the losses suffered so far this year.

There's also a ton of cash on the sidelines now waiting for a place to land, and despite significant drag on earnings care of the financial sector, there has been some broad resilience in a good number of other market sectors. PNC puts household cash at a whopping $8.5 trillion as of early June.

Unfortunately, with markets pressing new lows at the start of the second-quarter earnings season, there's little clarity as to the timing of any possible reversal.

As we move into the second-quarter earnings season, damage caused by what's expected to be a fourth straight quarter of negative earnings growth could have investors in a more forgiving mood. Thomson Reuters sees second-quarter earnings for the S&P 500 dropping 13 percent.

At the same time, however, the overarching concern for both equities and the economy continues to be the health of the consumer, and his or her expectations about where inflation is headed. Fears of '70s-era stagflation have increased along with oil, food, and commodity prices, but there's still no definite sign that price pressures are spiraling out of control. The core consumer price index, which excludes food and energy, is still subdued.

The argument against runaway inflation is this: Unlike the 1970s, American workers don't have enough pull in the form of unions or collective bargaining agreements to force management to hike pay even if inflation climbs. Obviously, that means nearterm pain for workers, but economists see a silver lining in a lower possibility of a wage-price spiral, in which inflation climbs to double-digit levels.

"Until the employee can go to the employer and ask for more money, consumers will just substitute buying that car or dress to pay for gas and eat," said Nick Raich, director of equity research at National City Corp.

Unfortunately, anything that hurts the consumer will be a drain on large chunks of the market that depend on robust spending, and few things raise their hackles like rising oil and gasoline prices.

As such, the final stone around the market's neck remains the high cost of oil. Crude may be off about $10 a barrel so far this week to around $136 on the Nymex, but that's still enough to keep gasoline prices high and consumers worried.

It also argues for more trouble in sectors like retail and autos, where stocks have already been battered this year.

Just last week, the threat of bankruptcy was raised for General Motors, and the auto giant is reportedly preparing deep job cuts and considering closing or selling some of its brands.

At the same time, investors still have to worry about financials. Banks and other institutions are currently somewhere in the middle of what we can call the "Great Deleveraging." Following the subprime and credit crisis capped off by the failure of Bear Stearns earlier this year, appetites for risk (and new investment) remain largely in check. Monday's drop in government-sponsored lenders Fannie Mae and Freddie Mac on worries over access to capital served as the latest milestone in a credit and mortgage crisis that's on track to generate $1 trillion in losses by some estimates. In the second quarter, financial sector profits are expected to slump by 67 percent.

The fate of a still-hemorrhaging banking sector remains possibly the largest unanswered question for the direction of equities. It's not set in stone that financials have to rise to get the rest of the market back on track, but there's little hope for a substantial recovery while those shares are falling.

So where to invest?

Strategists still tout U.S. large caps, much as they were doing at the start of the year. Back then, the weak dollar and exposure overseas were the main selling points for shares of global firms based in the United States. Now, with overseas market suffering more than the United States from inflation pressures, those same companies are seen as bets worth placing ahead of what many hope will be the beginning of the end later this year, to a recessionary dip that started in late 2007.

"It's going to be a rocky road for the rest of the year, but we would be more invested in stocks. The market is oversold. We could see more sell-offs, but the S&P will be higher at the end of the year than it is now," said Paul Hickey at Bespoke Investments.