GOING DOWN
S&P has had bad fall from its peak, but loss from the start of the year doesn’t stand out
S&P 500’s shockingly bad fall from its peak puts it well into a correction,
Wall Street forecasters had an unusually good first nine months of the year, as the S&P 500 soared to just above their average forecast for the year. Since then it’s all gone horribly wrong, and the prediction of strategists that the S&P would stand at 2875 by New Year’s Eve now looks completely out of reach.
Those with a historical perspective can think of this as just another normal year. But it also gives us a way to think about whether the selloff of the past three months might be the start of something much worse.
Here’s what history tells us. The S&P has had a shockingly bad fall from its peak and—assuming it doesn’t recover—the loss from peak to year-end has been worse in only a handful of years, almost all notable for recessions or crashes. On the other hand the actual loss from the start of the year, currently 6%, doesn’t stand out as especially bad. And the fall from the start of the year to the lowest point during the year has been worse in almost half the years of the past half-century. It just happens that we are currently at the lowest point in the year, which is unusual as the festive season gets into swing.
My favored interpretation of the recent selloff is that investors were wildly overexuberant, and that has faded back to a level of what might be seen as a somewhat more than normal level of concern. If this is right, the prospects are for a volatile period. Investors remain uncertain about key economic fundamentals, especially U.S.China trade talks and the fading European and Chinese economic expansions. Animal spirits might buoy up markets again, or investors might sink back into the sort of despond that ended 2015, but sentiment currently offers little guide.
Think back to the peak excitement that coincided with the Davos meeting of world leaders in Switzerland at the end of January. Investors thought the world economy had finally escaped the postcrisis shackles and was set for a period of synchronized global growth. Gauges of investor sentiment showed supreme confidence that everything was going great; one, the long-running Investors Intelligence survey of the attitude of investment newsletter writers, hit its highest since 1986. That was a solid sell signal.
Hopes of global growth faded rapidly, with European stocks and emerging markets tumbling as the Chinese economy struggled, hurt by the hangover from last year’s clampdown on lending and by U.S. tariffs. But confidence in the U.S. economy continued, with earnings expectations soaring along with the market until late September.
Since its peak the S&P 500 has dropped 14.5%, putting it well into what is known as a correction, a fall of more than 10%. A correction it is: The boom up to September was a mistake, and needed to be put right by a fall.
But sentiment is not wildly bearish. Some indicators, including the survey of a self-selecting group of members of the American Association of Individual Investors, show more bears than bulls, although gloom is not as deep as at the worst points of 2010, 2013 or 2016. Others are more positive. Options markets show investors rushing for protection, but not yet anywhere near as much as in 2016.
The newsletter writers are much less bullish, but still not overall bearish; Wall Street analyst downgrades outnumber upgrades, but not to the extent they did in 2011, 2012, 2015 or 2016.
Something similar holds for the earnings and economic outlook. Forecasted operating earnings for the S&P 500 next year are down from a rise of10% to a rise of 8%, according to IBES data—but that is still a rise. Equally, average projections for GDP growth next year collected by Consensus Economics have been cut from a high of 2.8% late last month to 2.5%, still above where they stood at the start of 2018 and above last year’s growth.
It is true that markets often work themselves up into a tizzy. Stock moves might gather downward momentum as falls lead to panic selling. Many economists fear that could in turn boost saving and so hold back growth (although the massive bull market since 2009 doesn’t seem to have done much to boost the economy).
And of course bad news could justify further falls. If the U.S.China trade talks fail and heavy new tariffs are imposed next year, stocks will surely drop further. If the Chinese don’t bring in new stimulus, and their economy keeps slowing, stocks may suffer more especially in Europe and emerging markets. And if the U.S. economy turns out to be more sensitive to rising interest rates than the Federal Reserve thinks, a slowdown next year could easily rekindle fears of recession and turn the correction into an outright bear market.
Investors who have no strong views on how these events will unfold should expect volatility, and hold more cash than usual both to take advantage of swings lower and to earn safe interest above inflation. Those who had the foresight to sell heavily into the irrational strength of the U.S. stock market in the summer should begin buying back, focusing on quality companies they will be happy to hold through volatile times.