Simply a correction or a looming bear market?
Stock market corrections (a decline of 10 percent) are a normal and healthy part of a bull market‡. We have all been concerned that we haven’t seen a correction since 2011, as the markets went virtually straight up with very little volatility. And then came August 2015.
We think this is a correction: a violent reaction to four primary factors.
- Valuations — Currently the market trades at a slight premium, as measured by Price-to-Earnings (P/E) multiples‡. Prior to last week’s trading, the market traded at approximately 17 times earnings. We think the market will trade at 16 times earnings, and if you assume the S&P 500 will earn $120 in 2016, the S&P 500 should trade at 1920.
- Earnings scare — Perhaps the market is now fairly valued; however if earnings estimates are in question, then the valuation of the market is wrong and prices may move lower.
- Global economic slowdown–China and other emerging markets are clearly slowing. China represents 14.1 percent of global nominal GDP‡.
- Lack of confidence in central bankers– Most historical bear markets‡ have come from Federal Reserve tightening and upcoming economic recessions.
The recent economic news was surprisingly good for the United States and even for Europe, perhaps suggesting that China is not the be-all and end-all of the world economy. U.S. housing data was especially strong this week with housing starts and existing-home sales reaching post-recovery highs. Those strong numbers should have a trickle-down effect on the U.S. economy as those homes are financed, furnished and remodeled.
China’s economy has slowed throughout the past few years and clearly is not growing at a 7 percent rate, the country’s official GDP growth estimate. Other variables such as electricity consumption, rail car volumes and airline traffic all point to a growth rate slowdown, but not a collapse. The question is how will China’s slowdown affect the U.S. economy?
U.S. exports to China account for 8 percent of total exports and only 1.2 percent of GDP. Admittedly, exports to other Asian economies account for another 15 percent of exports, but the risks of a widespread Asian financial crisis resembling what happened in 1997 and 1998 are quite low.
Many have cited the Chinese stock market as an indicator of their economic outlook. The 40 percent decline in the Chinese stock market since June has nothing to do with any deterioration in the Chinese economy, just as the 58 percent surge in the first half of this year didn’t reflect a genuine improvement in economic fundamentals. It’s worth remembering that the Shanghai composite index‡ is still up by 38 percent throughout the past 12 months.
The Federal Reserve (the Fed) has been clear that its decision to hike rates will be data-dependent. But is it also market dependent? We don’t think the Fed will ignore what is happening in the financial markets. The probability of liftoff in September has been reduced significantly. Most bear markets (a decline of 20 percent) come from Fed tightening and upcoming economic recessions. The Fed doesn’t want to commit a “policy mistake” and be blamed for a bear market or a recession.
Europe just initiated a quantitative easing program‡ earlier this year. This should bolster both its economy and investor sentiment, and mitigate downside pressure on its markets.
China’s policymakers also have plenty of scope for further stimulus, both monetary and fiscal. In fact, as I write this, China has lowered interest rates.
U.S. Stock Market
The last time we saw a correction using closing prices was in 2011, when from May to August the S&P 500 declined 11.1 percent. Last year we saw a correction in October; it was slightly less than a 10 percent correction and recovered quickly. Following are current returns as of this writing:
There is clearly a revaluation of global growth.
What does this mean for equities‡? Based on the recent market correction, it will be difficult for the S&P 500 to reach new highs in 2015. However, the average decline of all corrections greater than 5 percent since the 1920s may indicate that we are close to the lows for this year. The average peak-to-trough decline during a 5+ percent correction is -12 percent, which implies a low of 1870 on the S&P 500 or 3 percent lower at the time of this publication. Potential positive catalysts for the market to go back to recent highs include clarity on the Fed and China.
What does this mean for interest rates? Clearly, the Federal Open Market Committee (FOMC) ‡ might use recent turbulence as a reason to postpone initiation of liftoff for rates — the risk of being accused of making a policy mistake will likely mean there is no adjustment of rates at the September meeting. However, if we are correct that recent market turbulence has merely been a valuation reset, and longer-term economic outlooks remain reasonably stable, we expect rates to begin an upward move in the near future.
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