Monday, June 26, 2017

Market Pullbacks Should Be Expected

There have been plenty of reasons to sell stocks since the end of the financial crisis in 2008. The drumbeat seems to be getting louder as the postwar market advance approaches one of the longest on record.

Also contributing to some angst about the market's advance is the fact the last pullback/correction of greater than 10% occurred in February 2016. In other words the market has gone more than 16 months without a >10% pullback. As the below chart shows, market pullbacks of nearly 10% are a fairly common occurrence. The market's average intra-year decline equals 14.9%.

Another view of historical pullbacks can be seen in the below chart provide by Ed Yardeni. Evident is the 13.3% correction that ended in February 2016.

Then, looking at the post financial crisis market recovery, the uptrend has been pretty powerful and remains confined to a well defined channel, albeit nearing potential resistance near the top of the channel.

And putting the current market recovery in perspective, the below chart shows the magnitude of the advance versus the bull market that began in 1990 and culminated with the technology bubble in 2000. That ten year advance in the run up to the tech bubble generated an annualized return for investors of nearly 16%. In other words, that is a return that averaged about 16% per year over that ten year period. Contrast that return with the market's return from the top of the tech bubble to last Friday's market close, that is, over the nearly 17 year period (2000 to 2017) the annualized return for the S&P 500 Index is just under 3%. The annualized return over the entire 27 year period is just over 7%. All of these return figures are on a price only basis. The average long run return for the S&P 500 index is about 10%, so the market's current level, and if one includes dividends, is at worst, probably where it should be for a market that has delivered an average return over time.

The one factor that may have investors the most worried is that of valuation. Admittedly, a number of the valuation metrics appear elevated. The common one evaluated by investors is the price earnings ratio or P/E. The below chart shows several differing P/E valuation measures, i.e., Shiller P/E, NIPA P/E and the standard S&P 500 P/E. The P/E that appears the most elevated is the Shiller P/E as can be seen below. Other P/E measures do not seem as elevated though. Also, at lower inflation levels, the market does tend to trade at higher P/E levels as I have noted in prior posts. In short, a market generally does not correct simply because of valuation. What valuation does say is the magnitude of a pullback might be greater if the market valuation is an extended one.

Also important when evaluating the market P/E is looking at the direction of earnings growth. As the below chart shows, the recent advance that began after  the pullback in early 2016 has been supported by growth in S&P 500 earnings. There is one investment axiom that says stock prices follow earnings and that certainly seems to be playing out now with low double digit earnings growth expect for 2017 and 2018.

Lastly, in terms of the market's performance following the election, the current market return ranks as only the third best compared to the prior seven presidential elections.

It is difficult for any investor to predict a market correction. Pullbacks and corrections are a normal part of a market's advance as can be seen in the second chart near the beginning of this post. Importantly, we would say the underlying economic and corporate fundamentals generally remain good and we do not see a recession on the near horizon and this should be supportive of reasonable equity market returns over time. 

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