There is a behavior familiar to all drivers known as the Brake Light Shockwave. One tap on the brakes from a small, unexpected event on a crowded road, and traffic mysteriously backs up for miles. The stock market is having its own brake light moment, reacting to the China market sell off. Suddenly, events, which we have known about for months, such as the slow economy, rate rises, energy deflation and earnings revisions, come to the fore. Here are our points: 1. Rate Rise: if the Fed raises rates this year, it will be small. The average cycle tightening is around 4.5%. This one will be much less.
2. Market Behavior: this correction is much smaller than past ones and overdue. The market doubled from 2011 to 2015 without any real pause. Some sectors, for example energy, had already fallen while others, such as healthcare and some tech, were getting ahead of themselves with merger and new economy excitement. This disparity is part of a healthy market.
3. Valuations: We looked at some of the corrections from the last 20 years, shown below. The worst damage in market slumps comes not from lower earnings and growth, but from re-evaluations. So, back in the tech bubble the S&P 500 earnings ratios (a measure of value) fell to 26 from 33. Company earnings, meanwhile, rose around 20%. This time, valuations remain reasonable and the sell off appears limited to large cap stocks.
4. Selling Pressure: on Monday, we saw what is now common in the world of program and High Frequency trading: the market seized and prices were marked down but with little selling pressure. By the end of the week, it seemed that buybacks and pension funds were back in the market.
So, what do you do when markets correct like this? Nothing.
Bottom Line: Volatility and periodic corrections are normal especially after the strong bull market of the last three years.
--Brouwer & Janachowski, LLC
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