The current downdraft in stock prices has understandably sent the happy faces on CNBC running for cover as they try to figure out what went wrong.
After all, the U.S. economy is growing and the Federal Reserve has made it clear that interest rates won't be raised until the middle of next year. How could stocks have the temerity to sell off?
We need to think through whether or not this market slump is simply a correction, or a harbinger of the kind of sell-off that puts our hard won gains at risk...
The Signs of a Correction Were Always There
Signs that stocks were due for a correction were obvious to anyone paying attention.
At about 16x forward earnings, stocks are valued meaningfully above their long-term average of roughly 14x. The Shiller Cyclically Adjusted P/E Ratio, which measures earnings over ten years, is currently about 25.5 versus its mean of 16.6x.
Certain sectors like social media are trading at stratospheric multiples reminiscent of the Internet Bubble and are ripe for a sell-off. Stock prices are inflated by non-organic factors - years of zero interest rates, low effective tax rates, and enormous stock buybacks.
S&P 500 companies are on target to spend $914 billion, or 95% of their profits this year on buybacks and dividends according to a data compiled by Bloomberg and S&P Dow Jones Indexes.
Much of the money being returned to shareholders is being borrowed at low interest rates, but this is clearly unsustainable. Perhaps investors are starting to look ahead and realize that earnings are going to need something other than huge buybacks and low interest rates to sustain their elevated levels.
There have been technical signs pointing to a correction as well (a correction is a 10% reversal from a market peak). The performance of small cap versus large cap stocks is one sign that technicians have been worrying about.
The small cap Russell 2000 Index has now dropped more than 10% from its high in March while large cap indexes like the Dow Jones Industrial Average and the S&P 500 are less than 4% off their recent record highs. Small caps could dramatically outperform on a rally, should it arrive.
More important, however, is the fact that the Federal Reserve is ending QE this month. The last two times it ended QE, the S&P 500 fell by 7% and interest rates also dropped. Thus far, markets appear to be following the same script. The S&P 500 was only down 3.8% from its closing record of 2,011.36 on September 18 to 1,935.10 on October 7, so it would have further to fall to match those earlier episodes.
Over that same period, interest rates have declined from 2.63% to 2.35%. If markets hold true to previous form when the Fed exited QE, stocks could fall further and bond yields could drop even lower before markets reach a new equilibrium.
An Indicator of What's Really Happening
There are other factors at work this time that have to be factored into the analysis, primarily the strong rally in the U.S. dollar. The dollar has rallied against the euro from $1.37 to $1.25 since mid-July and from $102 to $110 against the Japanese Yen. These are huge moves that conventional thinking holds constitutes an effective tightening of monetary policy that could provide the Fed with an opportunity to further delay raising interest rates beyond 2015.
The Fed has downgraded its growth forecast based in part on the rise of the dollar. A stronger dollar also hurts the earnings of multinational corporations as well as energy companies (since oil is purchased, for the most part, in U.S. dollars), so a strong dollar could actually create another headwind for stocks. That remains to be seen.
The one undeniable fact that is confirmed by both economic and market data is that the global economy outside of the United States is faltering. Japan is back in recession, Europe is about to join it, Latin America is a basket case with Argentina and Venezuela in crisis and Brazil stumbling, and China is slowing and dragging down the emerging markets.
Only the U.S. is growing (and has grown at better than 3.5% in three of the past four quarters). But U.S. growth has come largely courtesy of zero interest rates that are expected to end within the next year, throwing the outlook for growth into question. The best explanation for the current market correction may be that investors are acknowledging that global growth prospects are dim. Certainly the rally in bonds would confirm that.
Keep This in Mind When Looking for Discounts
Despite these ominous signs, it must be remembered that a correction is not a bear market.
A bear market is almost always preceded by a recession which in turn is normally preceded by an aggressive tightening of monetary policy that pushes short-term interest rates higher than long-term interest rates (flattening and then inverting the yield curve).
Every bear market in stocks has been preceded by an inverted yield curve. The Treasury yield curve has flattened significantly in 2014 but has not yet inverted and remains relatively steep, suggesting that both a recession and a bear market remain highly unlikely.
But a correction can still do a lot of damage and investors should buy cautiously when they buy on the dips.
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About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.