The Dow Jones Industrials exhibited unusual volatility last week. After the euphoria of the successful Alibaba IPO, the Dow suffered successive losses, topped by the 264-point loss on Thursday that represented the largest drop in two months.
After Thursday’s broad retreat, speculation increased about the beginning of a bear market. However, a 167-point rally on Friday recovered almost half of the losses, as the Dow closed at 17,113, down nearly 1% for the week.
What caused the sell-off of Thursday? Perhaps more importantly, are we truly reaching the beginning of a bear market?
Those who consistently predict a bear market will forge ahead with new ammunition after this week. The Dow sell-off has the bears wondering if the blue chips are finally coming down to earth to meet other equities.
Almost half of the companies in the NASDAQ composite are down 20% or more from their peak within a 12-month period, and other indices such as the Russell 2000 are also doing poorly. The Dow stands in stark successful contrast.
Still, the Dow fundamentals are solid if a bit overvalued. The forward P/E ratio for the Dow is at 16.03, which is closer to average than high, by historical standards. Analysts are generally predicting corporate earnings to continue to be strong, and the recent upward revision of the second quarter GDP to 4.6% growth suggests that more broad-based economic growth could finally be underway. In addition, we should note that September, for whatever reason, is historically the worst month for stocks.
Some chief investment strategists argue that we may have experienced the top for this year, but see at best a minor correction with a bear market unlikely in the short term. Edward Yardeni of Yardeni Research predicts a volatile sideways market throughout the rest of 2014 with growth resuming more robustly in 2015.
Bob Doll of Nuveen Asset Management believes that collective negative influences led to the recent drop, such as slowing growth in China, Europe’s weakness, and increasing geopolitical instability. However, Doll believes that the true trigger will eventually happen when the Federal Reserve raises interest rates, or the system receives an “exogenous shock, like a 30% rise in the price of oil overnight”, adding that “bulls don’t end from old age or high valuations.”
In a recent Forbes article, Panos Mourdoukoutas drew a distinction between the types of prosperity that drive Wall Street. Real prosperity, such as the 1980’s bull market, is driven by innovation, new industries, and job opportunities. “Paper prosperity” is caused by the artificially low interest rates of central banks inflating the value of assets.
Paper prosperity creates an inherent mismatch between intrinsic and market values, meaning that when a correction does occur, it is likely to be sharper. Arguably, we are in a period of paper prosperity. The question is, when this correction occurs, is it large enough to trigger a longer-term bear market?
It appears that simple profit taking was going on after the Alibaba IPO produced an exuberant peak – whether we call it rational or irrational. It is also possible that the Thursday sell-off was in response to a collective breaking point in uncertainty for some investors. In any case, the Friday rebound suggests bear market predictions may be a bit premature.
Another dip in the Dow similar to the ones in late January and late July would not be a big surprise, because of the hair-trigger that many investors possess. Investors in equities know a correction is inevitable and overdue, and the longer it takes the correction to hit, the more people will be willing to look at any event as the one that finally triggered the losses.
In our opinion, the thing most likely to trigger a correction is when the Federal Reserve finally gives enough warning about an imminent raising of interest rates that investors stampede trying to beat the crowd. However, considering the worldwide factors – both economic and geopolitical – there certainly could be a large enough shock to spook the investing herd. There have been plenty of smaller shocks lately, but not any one big enough to spark a correction.
It appears that, for the moment, it is prudent to keep the powder dry on your equity holdings, and monitor the worldwide news as closely as the market news.