As usual when the market corrects, it creates fear in investors, me included. The once bullish sentiment seems to give way to the bearish outlook. Here we want to share why market down is good news, if this is the start of a longer-term correction. It may be a temporary rest for the bull to run further.
So that you can keep your perspective in check, and make sure that your long-term investment strategy is still intact.
First, let’s understand the lag effect between the fundamentals of the economy and the stock market.
The Lag Effect of Fundamentals And Market Behavior
Source: StockCharts / Sector Rotation
Economy Down, Market Up – Why Market Down Is Good News
According to Jim Paulsen, chief investment strategist at Leuthold Group, a market research and money management firm, says that, “Most bull markets of the last 40 years commenced when company fundamentals and earnings were still declining from a recession.”
This is exactly what we have seen during the market crash when the coronavirus broke out in March 2020. Governments all over the world are imposing restrictions. Businesses need to be shut down. Companies’ earnings are affected and declining for the rest of the year. Yet, we saw a very strong bull run very quickly following the March 2020 correction.
Not only that, investors are valuing companies at higher multiples. The pandemic has caused earnings to fall during the year. Yet, the average Price-to-Expected Earnings (P/E) ratio climbed from less than 15 times to more than 23 times.
This is understandable as investors took the environment of declining profits as an opportunity to enter the market. Because they are anticipating the eventual recovery and higher profits in the near future.
So, understand and acknowledge this phenomenon of the stock market’s behavior differing from the actual fundamentals of the companies and economy in general.
Economy Up, Market Down – Why Market Down Is Good News
Similarly, this lag effect happens in the opposite direction as well. As Jim continues, “Once confidence about a new economic recovery emerges, stock valuations are often stretched even farther by a rise in bond yields. Consequently, within the first 12 – 24 months, a new bull cycle usually experiences a period of hesitancy, a pause, or a correction.”
Again, this is what we have observed in the market recently.
With the S&P 500 reaching an all-time high on 7 May 2021, investors are getting more wary of the inflation risk. Sustained high inflation level could induce the Fed to raise interest rates sooner than expected. This definitely hurts the stock market. Because, if this expectation turns into reality, it will make bonds more attractive than stocks.
So, we have seen companies’ earnings growing at an unprecedented rate recently. And the average P/E ratio is reaching just under 21. With the concern of rising bond yields, it will make stock investment less appealing and cause valuation multiples to fall.
In fact we have seen such market behavior many times in the past.
Learning From The 1990s
Source: Marotta Wealth Management / The No-Bear Bull Market of the 1990s
Take the bull market in the 1990s as a case study.
From the beginning of 1990 when recession started, the S&P 500’s P/E ratio climbed from under 15 times to almost 25 times in 1993.
Similar to the recent pandemic-induced recession, back then shares were rallying as the market expected the eventual recovery of businesses. Yet, during the beginning of the recession, companies’ earnings were still falling.
Once the market sensed a positive comeback of the economy in early 1995, S&P 500’s multiple fell back to 17 times instead. This is despite companies reporting higher earnings back then. So, the stock market slowed down, exactly like what we have seen recently in the market.
In fact, after the 1995’s correction, the bull market ran for a few more years before the dot-com crash in 2000.
Why Market Down Is Good News: What Can We Learn
Source: TheStreet / Biggest Stock Market Crashes in History
So, now you can see how the lag effect between the companies’ fundamentals and market behavior in our current market’s recession-recovery phase, actually followed a very similar pattern to the past.
If this is the start of a longer-term correction, it may lay down a runway for the bull to run further in the years to come.
In short, a market correction in 2021 shouldn’t come at a surprise. And it may not necessarily imply that the bull run is out of gas. It may just be transient, and paving the way for further run upwards.
Anyway, the reason for sharing this is to help you put things in perspective for the long term.
Don’t let the news and short-term pessimism move you to follow the herd and sell your stocks as well.
Keep a clear and logical mind, assess the individual’s business and see if there’s any change to its fundamentals. And remember why you bought into them in the first place.
If nothing has changed, then just sit tight and be patient.
As Buffett says, “To make money in stocks, you must have the vision to see them, the courage to buy them, and the patience to hold them.”
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Keep learning and happy investing. 🙂