When you look at this week’s stock market madness, remember: “To infinity and beyond” was a catchphrase made famous by a toy action figure hero, Buzz Lightyear, in the 1995 movie Toy Story, and not a motto for investors.
Yes, we’re in the midst of one of those periodic unpleasant market phenomena known as a correction. Unpleasant? Well, other, less polite and more vivid words might better describe what it’s like to be in the heart of the action, whether you’re a trader trying to figure out precisely what is going on or an investor wondering if the magnitude of the selloff will derail your plans to retire next year.
And you’re probably sick to death of people telling you to be patient; not to panic; that it’s normal to feel anxious but that you need to stay calm; to be prepared to look for value and buy on the dips.
I’ve watched market hiccups, corrections, brutal selloffs, flash crashes and utter meltdowns of all kinds dating all the way back to the late 1980s. I started writing about them in 1997 when emerging markets in Asia (deja vu all over again) triggered panic among investors here in the United States. There followed a repeat of the “submerging markets” crisis the following year; the dotcom market meltdown, the market woes triggered by accounting scandals, and of course, the grandaddy of them all, the 2008 near-apocalypse. In between, there have been one-day events (the flash crash), sector events (a meltdown in biotech stocks here and there; a rogue trading scandal in the metals industry), and other dramas (the blowup of Michael Milken’s junk bond empire, for instance).
If there’s one takeaway from all of this, it’s the importance of context when you’re trying to figure out whether it’s really time to convert your portfolio to gold, ammo and food with a 25-year shelf life, and bug out for that off-the-grid cabin in the hills. And here’s what you need to know about the context of the current correction.
Valuation. Before this bloodshed got under way, stocks were overvalued by pretty much any metric you’d care to apply to them. The price of any stock is an assessment of its future earnings: the higher its price goes relative to past earnings, the greater are the expectations of investors for the ability of that company to deliver blockbuster growth in profits. All that is expressed in its price/earnings ratio, or P/E ratio. While market pundits bicker a lot about what a “normal” P/E ratio looks like for the Standard & Poor’s 500 index, its historical mean has been 15.55 and historical median has been 14.6. So if you argued that historically the S&P has tended over the long haul to revert to the level of trading at about $15 for every $1 of earnings the companies in the index generate each year, you wouldn’t be far wrong.
After the stock market began its climb out of the depths in early 2009, it was dirt cheap by those standards – and remained so until as recently as 2012. By June 2015, the S&P 500 was trading at 20.5 times trailing earnings, and 18.6 forecast earnings, and some advisers were warning it was time to lighten up cash positions; that the market was simply too pricey. They were right. And guess what? It’s now trading back below 15 times earnings. The Dow Jones industrial average, meanwhile, trades at about 13 times next year’s earnings. That’s real value.
It’s August. Before you laugh, stop and think. Are you working flat out, or are you in countdown to Labor Day? Getting kids ready to go back to school, enjoying the last days of summer vacation? Yeah, exactly. Well, exactly the same thing is happening in the financial markets.
Mike Driscoll, once a trader for investment banks and hedge funds and now a professor and senior executive at the Robert B Willumstad School of Business at Adelphi University, has watched this phenomenon first hand. “I used to love bloodbaths sitting on a trading desk,” Dr Driscoll said, nostalgically. “They blow when you are on the outside, though.” That may be in part because someone who isn’t part of the trading fraternity doesn’t realize just how anemic trading volumes become during August: it’s the month when trading thins out to a degree exceeded only by major holiday periods like Christmas and New Year’s and, sometimes, by February. That means a small wave of buying or selling can have an exaggerated impact: there’s no one ready to respond and push back in the opposite direction.
Then, too, as Dr Driscoll pointed out in a recent commentary, trading desks are staffed by the B-Team. It isn’t that they aren’t in touch with their bosses, whether the latter are out in the Hamptons, attending the US Open, or hanging out in the Napa Valley or the Dordogne. But the managers aren’t sitting on the desk, making minute-to-minute decisions about how to navigate the market and seize opportunities. Their risk-averse juniors are likely to simply sell, and sit on the sidelines. As the old market saying has it, why try to catch a falling knife? Wait until September, when both the A-Team and the trading volumes are back.
The Fed. We’re only three weeks away from a critical meeting of Federal Reserve policymakers, at which (until now) pundits had widely been expecting to see the first interest rate hike in nearly a decade and the first change in interest rate policy by the Fed since the heat of the financial crisis. The stock market rally is largely a creation of the Fed: with interest rates near zero, where else were investors supposed to park their assets, even as valuations rose into nosebleed territory?
The prospect of boosting interest rates when the economy is only sort of strong, rather than unequivocally robust, still unnerves enough investors to add fuel to any kind of market panic. Especially since while rates go up, bonds will be lousy investments: as rates rise, the value of bonds declines. That’s going to leave stock market investors without an appealing safe haven if the sell-off is prolonged or repeated. Ouch.
The fundamentals. The irony is that while the catalyst for the US correction is what’s happening in China, there is a limit to the extent that that will affect the US economy. And so far, that economy looks reasonably healthy. Goldman Sachs has just published a list of 25 stocks whose stock prices have plunged by some 20% since May that have minimal exposure to China, and instead rely mostly on the US for their sales, to show the extent to which the market is tossing out the proverbial baby along with the bathwater. (I might ignore the oil and gas companies on this list, given what has happened and is likely to continue happening to commodity prices, but the idea is valid, and the list includes names like Macy’s, Whole Foods Market, KeyCorp and E*Trade Financial.)
Here are the US fundamentals: second-quarter GDP was revised upwards and new home sales and consumer confidence rose, with the latter in August hitting its highest recorded level since the beginning of the year. Even home builders are more bullish about their business than they have been in a decade, since before the subprime lending market blew up and sent things into the doldrums. Corporate earnings are still growing – and if you exclude the troubled energy sector, profits are growing at a healthy 8.9% clip, according to data from Thomson Reuters I/B/E/S.
The bottom line? We’re in the midst of a long-overdue correction that will leave us with a market that is less overvalued. We won’t have to squint and rationalize our decision to invest more in the S&P 500 as it moves from a P/E of 20 to 21 and higher still, toward infinity.
Some statistics to ponder: this has been the third-longest bull market in the last half a century. Of the 35 corrections of 10% or more in the last 15 years – yes, 35 of them, most of which I’ve written about – the market has recovered all lost ground in less than a year’s time. The odds – and the context – suggest that this pain, too, will end.
