Thursday, October 9, 2014

Root for a Correction

by Matt Malick and Ben Atwater
Root for a Correction

In market parlance, the textbook definition of a correction is a drop of greater than 10%, but less than 20%.  Any fall of 20% or more is considered a bear market.

Commentators often talk about a correction as a healthy phenomenon.  But, when one happens, it feels terrible – like it is never going to end.

It has been so long since we have had a correction - April 29, 2011 through October 3, 2011, when the market fell just over 19% on a closing basis - we almost forget how torturous they really are.

Presently, the Standard and Poor’s 500 has declined, as of yesterday’s close, 3.77% from its recent all-time closing high on September 18th.  This is far from a correction, but painful enough, especially given the dramatic underperformance of small-cap (Russell 2000) and international equities (ACWX) relative to the S&P 500.

However, a correction can be beneficial as long as investors don’t panic and make poor decisions.  If we are in the process of one, it would serve to make valuations more reasonable, dampen investor sentiment and provide a potential catalyst for a move to new highs following a successful earnings season.

As we approach earnings season, analysts are expecting S&P 500 companies to earn $29.69 per share in third quarter profits, which would leave the S&P 500 with trailing twelve month earnings of $108.27.  If the market were to correct in the meantime and fall 10% from its closing high to 1810.22, the price-to-earnings ratio on the market would fall to 16.71.  Although this valuation is not dirt cheap, it is close to the long-term average P/E and highly attractive when we compare bonds, real estate and various other asset classes to stocks.

Furthermore, when the market falls, investors almost universally get more pessimistic about the prospects for future returns.  And sentiment is a contrarian indicator.  If a correction shakes some of the fickle money from the market, then the market’s foundation is stronger when it begins to rise again.

As you well know, we believe excess valuations and sentiment are generally the preconditions for a bear market and corrections help dampen both.

Finally, if the market does continue to fall here, then a positive earnings season could be a catalyst to spur the market to new highs.  After all, if earnings meet or exceed estimates, we will then have back-to-back quarters of 9%-plus earnings growth, a seemingly bullish happening.

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