Analysis: Don’t panic. After a massive rise in stock values, this recent sell-off is probably pretty healthy.
For those breathing a sigh of relief after the stock market enjoyed a rebound Tuesday, the bad news is this sell-off probably isn’t over yet.
On the other hand, that’s not something necessarily to be afraid of.
In a look at what happened to the markets every time the Dow fell 4.6 percent in a single day, as it did on Monday, the sobering news is that 80 percent of the time, the market had not recovered within a month. The good news is that 80 percent of the time after a sharp daily dip, the market recovered within a year.
How key Northwest companies fared Tuesday
T-Mobile US: -1.12%
Source: S&P Capital IQ
The historical data is a reminder that the stock market may get worse — or at least go sideways — for a while. But the historical data also confirms what many longtime investors will tell you: Don’t panic. After a massive rise in stock values, this is probably pretty healthy.
“I don’t think the decline is over. I expect this will ultimately be relatively short-lived, but I don’t feel like it’s over today,” Kristina Hooper, chief global market strategist at Invesco, said Tuesday. “Valuations are still stretched.”
The stock market run-up was rapid before this latest dip. It’s why just about everyone was saying, before the declines of the past week, we were overdue for a correction. The Dow was up about 26 percent from January 2017 to January 2018, an increase that is over three times the typical annual gain of 8 percent.
A volatile market
Tracking the Dow Jones industrial average’s last four days of trading
Feb. 1: +37
Feb. 2: -665
Feb. 5: -1,175
Feb. 6: +567
On top of that, some individual stocks were especially turbocharged. Netflix, for example, was up over 40 percent in January alone. And it wasn’t just tech stocks experiencing the surge. Boeing jumped over 20 percent in January. Even after the pullback, Netflix and Boeing have only given back about 5 percent of the massive gains.
“I don’t think we were in bubble territory, but we had a very, very extended run. We had stocks that had moves in January that you just can’t sustain every month,” said trader Tim Anderson, a managing director at MND Partners. “It was time to wring excesses out of the market.”
Still, overall, the market looks less expensive now than it did before the sell-off. A popular gauge of how expensive the market is called the “P-E ratio,” which looks at stock prices divided by expected earnings, is now at 16.9, down from the frothy 18.2 before the recent decline.
But it’s still above the historic average of about 16.5, which suggests there might be a bit more to give back.
This doesn’t mean the bull market is over for equities. But investors have clearly had a mindset shift in recent days. It wouldn’t take much to trigger some more down days.
Technically speaking, we haven’t even had a true correction yet.
A correction happens when the stock market falls at least 10 percent from its previous high. The most popular stock-market indexes — the Dow, S&P 500 and Nasdaq — all hit records on Friday, Jan. 26. On Tuesday morning, the Dow briefly traded down 10 percent from that Jan. 26 high, but then it rebounded and ended up closing well above a correction.
The S&P 500 and Nasdaq still haven’t hit correction territory, not even temporarily.
“From a technical standpoint, no, we haven’t hit that correction yet,” said David Lebovitz, global market strategist at JPMorgan Asset Management. But he argues that because 2017 was such a calm year in the markets, what we just experienced felt like a correction and had the same effect on investor psyches of “getting investors’ attention and shaking lose some of the fast money.”
Hooper, of Invesco, has dubbed it a “flash correction” since it happened so fast.
But this week isn’t over yet, let alone this month. It’s still possible we could see the market close in correction. Historically, the stock market would experience a correction about once a year. It’s just in this latest bull market that started in March 2009, the Dow has experienced only four previous corrections (i.e. one about every two years).
And the average correction doesn’t last long, but it lasts longer than three days. Since 1945, the typical length of a correction is 71 trading days — or about 2.5 months, according to MarketWatch.
“I think we are closer to the end than we are to the beginning, but it’s not time to sound the all clear,” Lebovitz said.
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Here’s what to watch for going forward.
First, have the economic fundamentals changed? Overall, the U.S. economy still looks very healthy. Unemployment is low. Consumers and companies are opening their wallets and spending. The main worry is that the economy might overheat and the Federal Reserve might make a mistake and raise rates too quickly, but none of that has happened yet.
The market will be watching the incoming data closely in the coming weeks, especially on wages and growth.
Second, have the corporate fundamentals changed? Companies are reporting very strong earnings lately. The recent tax cuts are making companies more profitable and lifting sentiment among many business owners. Overall, companies seem to be in great shape, but some stocks are still pricier than others.
Investors will be watching for stocks that are gaining or losing too much, like what happened in January.
Finally, watch for more “flash crashes” — superfast drops like what the market saw Monday at 3 p.m. when the Dow shed about 1,000 points in a matter of seconds. Most blame computer trading for that rapid decline.
Those computer “technical trades” could easily pop up again if the market starts to fall quickly later this week or month. Keep an eye on those movements. It’s a sign more factors are at work than just the “fundamentals.”
“These computerized selling models are written by people who don’t understand all the mechanics of the market,” said Anderson, of MND Partners.