• Wealth Management

Understanding the Recent Market Swoon

Stocks have stumbled, but it seems like a rational response to current conditions and may not lead to further declines.

A brief market downturn may not be most investors’ idea of a good time, but it isn’t always a bad thing. In the case of the recent swoon in stocks, which are off about 7% from their highs, I’d argue that the repricing was long overdue and a rational response to current market conditions.

I don’t want to put too much of a gloss on events that may have been painful for some investors, but the sell-off has actually alleviated some of my recent concerns about complacency in markets. I was worried that stocks hadn’t priced in risks, such as slowing global growth, more Fed hikes on the horizon, escalating trade tensions and slowing corporate earnings growth.

Now they have. The S&P 500 forward price-earnings ratio, a common measure of a stock’s valuation, fell from 18 in January to around 16 currently, a more reasonable level. I take heart that the sell-off was orderly and wasn’t marked by signs of fear—like a rush to buy U.S. Treasuries. It had the biggest impact on the most overvalued stocks, many in the tech sector.

What’s Next?

I expect the market to be range-bound and don’t see a lot of upside for the S&P 500 from here, mainly because of the risks I’ve already cited. I suggest investors stay in stocks, but rotate out of pricey growth stocks and into value-priced names in more defensive sectors.

Next year, rates are likely to rise even more and financial conditions for investors could get more difficult. If credit spreads—the difference between the yields of corporate bonds and Treasuries—start to widen (a sign that investors are worrying more about corporations paying back their debt), that could provide an early warning.

In general, I suggest keeping an eye on interest rates. The apparent catalyst for the recent sell-off was a rise in Treasury yields. The yield on the 10-year Treasury note jumped to 3.2% from 2.8% in August. When interest rates rise, investors may discount the value of future earnings, leading to lower stock valuations.