Given the global market implosion that occurred on Monday, August 24th, we sat down with S&P Capital IQ's Chief Equity Strategist to ask him some questions on what exactly happened and what he thinks will happen next.
Q: What do you think caused the large drop in the stock market on Monday, August 24th?
A: I believe this has been a fundamentally driven sell-off triggered by growing concerns over a global recession, precipitated a year ago by slumping oil prices, but more recently by weakness emanating from China, a possible U.S. profit recession and finally the Federal Open Market Committee (FOMC) seemingly getting cold feet about raising rates in September. The selling appeared to stop at critical technical support levels: 2035 on Thursday, 1970 on Friday, and then 1893 on Monday.
Q: Did you see this coming or were you taken by surprise?
A: The quick answer is “Yes.” We knew a meaningful decline was coming, but we didn’t know exactly when it would strike. S&P Capital IQ’s Investment Policy Committee (IPC) had been reminding investors for quite some time that the S&P 500® had gone a very long time without a decline of 10% or more (it ended up being 47 months, compared with the average of 18 months since 1945).
We also told readers of our IPC Notes that valuations were at best on par with long-term averages and at worst trading at significant premiums (depending on whether you looked at trailing or projected, operating or GAAP earning that were or were not inflation-adjusted). We even reminded readers of seasonal weakness, especially in August. That said, no, we could not have foretold that the S&P 500 would undergo such a steep and swift selloff starting on a particular day.
Our goal is encourage investors to have an appropriate exposure to equities, based on their investment goals, time horizons and levels of risk tolerance. We also remind them, usually late in bull market cycles, not to go too far out on the risk curve. In addition, we encourage them not to become their portfolio’s worst enemy by being ruled by their emotions and selling out at what usually becomes the market low.
Q: When was the last time the market declined this much?
A: The DJIA has never lost this many points in a single day. Yet the 588-point decline pales by comparison with what was experienced in 1987. To equal the more than 20% one-day decline suffered on Black Monday, October 19, 1987, the DJIA would have needed to fall nearly 4000 points on a closing basis today.
Q: Do you think this is a correction or the early signs of a bear market?
A: No. Economically, while the U.S. economy continues to grow at a sub-standard rate of pace, housing and employment data tell us that our economy continues to be in expansion mode, rather than at the start of a topping out period. What’s more the yield curve (10-year yield minus the 3-month yield) remains steep. Encouragingly, this yield curve has never gone inverted while inflation has been below 2%. (An inverted yield curve happens when short yields are higher than long yields, and is a common early warning signal for a recession and/or bear market.)
Q: What can history tell us about what to expect in the near future from the market?
A: First, a “pop” after the “drop.” Despite the more than 10% drop, history says we could see a pop this week. During the current bull market, whenever the S&P 1500 fell by 4% or more, the market gained an average 2.3% in the following week, and registered a price advance 80% of the time. What’s more, since 1945, the “500” gained an average 1.6% in the week after a 4%+ decline and rose 66% of the time.
The speed (or lack thereof) with which the S&P 500 finally succumbed to the 5% decline threshold may offer a clue to the likely magnitude of the overall decline. It took the “500” 92 calendar days to fall through the 5% decline threshold, the longest since WWII. The speed of decline, in our opinion, is reflective of investor behavior. For those 16 times that the S&P 500 took its sweet time (40 days or more) to fall 5%, the “500” never fell into a bear market, possibly because drawn-out decline gives investors time to evaluate the concerns and dissipate the impact.
That said, this correction might not be done, and the S&P 500 may end up losing more than the current 11% (but less than 20%) before this correction is over. Investors are advised, however, not to try to time the market. You may get out in time to avoid further carnage, but you probably won’t know when to get back in, and will likely do so at a level higher than where you exited. Investors are usually caught flat footed, as corrections have tended to recover all that was lost in only an average of four months since WWII.
Finally, remember that equities have traditionally done very well whenever inflation has been low. The “Rule of 20,” which computes fair value for the S&P 500 by combining P/E with inflation, indicates that the fair value for the S&P 500 is currently around 2140 using Q3 2015E operating EPS and the annual change in Core CPI at 1.8%.