• Wealth Management

Putting the Correction in Context

The recent market downturn has been painful, but it isn’t particularly surprising. It could set up stocks for more gains ahead.

A sharp drop in markets, even when followed by a rebound, can be a shock for investors. We’ve had a few of them lately and they come after a period of near record low volatility, making them even more jarring.

Seen in context, however, the size of the current downturn in markets isn’t especially surprising. In fact, I see this as a garden variety correction, which is loosely defined as a market drop of at least 10%. I am becoming more positive about market fundamentals, although I think higher volatility is here to stay.

This correction was not unexpected considering euphoric equity markets and global financial conditions that were among most accommodative on record (see, “The Case for Cash,” from mid-January). Higher interest rates, which bumped up due to factors like rising inflation expectations, a weaker dollar and growing national deficits, appear to have fueled the declines.

While the peak-to-trough decline of 12% isn’t out of the range for a normal market correction, it happened a lot faster than usual. Popularity of algorithmic trading, niche investment products tied to volatility and passive exchange-traded funds exacerbated the speed of the downturn.

Where We Are Now

It’s important for investors to note that the correction was not prompted by economic fears, a collapse in corporate earnings prospects or a geopolitical shock. It’s also encouraging for the health of the market that corporate bonds have not sold off sharply. Even riskier high yield bonds have held up relatively well.

Since stock prices have fallen while corporate earnings estimates are being revised higher, equity valuations are more attractive. The forward price/earnings ratio of the S&P 500 has fallen to 16 from 18. That’s a big reason why I believe the S&P 500 can reach 3,000, our bullish case, at some point in the next 12 months (our base case is 2,750). But it will continue to be a wild ride and interest rates may head higher. The Federal Reserve has indicated it could raise rates three times this year. Avoiding a policy mistake in the current environment could be challenging.

Bottom Line: I think this is a good time for investors to return to tried-and-true risk management techniques, like diversification (including into foreign markets) and active portfolio management, as opposed to indexing. Bond markets may remain under pressure, but I think stock markets will be higher in the next six to 12 months. As the year progresses, I will be watching inflation expectations and earnings revisions closely to gauge if my optimistic outlook is still warranted.

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