Over its last six trading sessions, Wall Street finally corrected — and how. Friday was the worst day for blue-chip stocks since August of 2011, with the Dow Jones Industrial Average falling 531 points. Tack on a steeper drop of 588 points Monday, August 24, and the total carnage over the past six trading sessions is nearly 1,600 points.
This represents a 12% decline since the market peak of 18,312 on May 19th, meaning the Dow is now officially in a “correction” phase. (Any drop of 10% or more in a bull market is considered a “correction”.)
The broader US equity markets also bled. In the past two trading sessions alone, the S&P 500 fell 142 points, while the NASDAQ tumbled 351. NASDAQ is now down 11.1% from its latest peak, joining the Dow squarely in correction land. The tech-heavy NASDAQ's retreat is being led by Apple (NASDAQ:AAPL), which moved beyond “correction” into bear market territory by closing at $103.31 today—a full 21% off of its peak earlier this year. Well over $1 trillion in US market value was erased over the Thursday-Monday free fall.
Global stocks sold off broadly as well. The Shanghai composite fell 4% on Friday and another 8.5% today, meaning it has now plunged over 38% in 2015. (However, the Shanghai is still 43% higher than it was one year ago, which illustrates just how volatile the Chinese equity markets have been.) Japanese stocks, meanwhile, fell 3% on Friday and 4.6% today, while the STOXX Europe 600 lost nearly 7% in the past two trading sessions.
Many reports pin this massive pullback in equities on three words: China, Oil, Fed. Chinese economic concerns, low oil prices and shaky demand, and the inevitable interest rate increase by the Federal Reserve have investors in a gloomy mood and looking for a reason to sell. Other reports cite continuing Greek instability as a factor, with the resignation Friday of Prime Minister Tsipras triggering a call for new elections there. While all these factors are clearly affecting the timing and severity of this global retreat from equities, there is an argument to be made that this correction was long past due for a host of fundamental reasons.
The long and strong bull market has dulled some perspectives on stock market corrections. Historically, they tend to occur around once every 18 months. It's been essentially four years since the last correction in the fall of 2011, which was fueled by the debt-ceiling crisis. There have been a few significant drops since then periodically to bleed off market enthusiasm, but nothing reached correction level until Friday.
Stocks have been arguably overvalued for some time. Stock prices have continued to rise out of proportion with earnings reports — revenue alone did not support current prices. Combine that with prolonged low oil prices (which fell below $40 per barrel for US benchmark crude), and a highly anticipated interest rate increase by the Fed, and the market was primed for a sell-off.
China provided the initial catalyst with a devaluation of the yuan last week, prompting concerns that China's economy was in worse than expected shape. A poor manufacturing report sparked the Friday decline and propagated the effects throughout Asian markets and on to Wall Street's opening bell. The preliminary August Caixin purchasing managers index, a measure of China's manufacturing growth, came in at 47.1, the lowest level since March 2009. Collective market fear was reflected in the CBOE Volatility Index (VIX), which reached 28 — more than double the previous week's value.
One bright side for investors may be a reluctance of the Fed to raise rates in September as most analysts had predicted, although artificially low rates are arguably part of the reason stocks were overvalued. Market forces should be driven by reasonable estimates of earnings and growth instead of incessant speculation on the Fed's actions.
It's hard to envision this drop as the beginning of the Great Recession Part Two. The fundamentals are not in great shape, but they aren't in extreme danger territory, either. Price to earnings (P/E) ratios are elevated but not at the levels seen prior to previous bubble crashes and bear markets. The housing market is finally beginning to show sustained recovery, and is hampered more by an inventory problem than anything else. US GDP was up 2.3% in the second quarter and the first quarter loss was revised to show a slight expansion of 0.6%. Consumer confidence is down a bit but not to the level that indicates future trouble.
The real concern is where future growth will come from, since consumer spending is not robust enough yet to drive demand even with low gas prices. Stock buybacks and mergers will still continue to pump up P/E ratios, but in the end, everyone realizes that true earnings growth must drive the market. Second quarter earnings reports were mixed and third-quarter projections were lukewarm at best.
China held promise for being the world's growth market, and the one-two punch of a devalued yuan and poor growth indicators have greatly decreased these expectations. Analysts are starting to wonder how much of the Chinese economic growth is real and how much is a debt-driven, government-obfuscated mirage.
The market might continue selling off, as the psychology is clearly skittish right now. However, it’s anyone’s guess as to whether a full-blown bear stampede is imminent. If equity prices do continue falling, look for bond prices to rise as investors seek refuge from stocks. The psychology of the sell-off is still in motion.
On the other hand, this correction might be short-lived as the fundamentals of the US market are still relatively strong. Both job and income growth are solid, interest rates remain low, while most major companies have healthy balance sheets and strong cash reserves. Consequently, the market may soon find a bottom and begin a slow recovery. China does not appear to have control of its economic situation yet, and the current state of both the Chinese and global economies is likely to keep any US recovery muted. Nonetheless, we believe the US market will reach a new equilibrium and begin the recovery process sooner, rather than later.
Broad sell-offs offer good buying opportunities for stocks that are still solid but dragged down temporarily by collective market forces. If it fits within your risk tolerance to buy during a downturn, there should be bargains available soon that will prosper in the longer term, even if they continue to slide in the short term.
If you do choose to go bargain hunting, keep your purchases within your established rules for diversity and total risk tolerance. If you cannot bring yourself to buy during a falling market, at least resist the urge to dump stocks completely. Avoid panic selling and seek partial refuge in cash, bonds or real estate. Then, during the recovery period, assess the damage to your portfolio and see if your diversity strategy served you well. If not, go forth and rebalance.