BREAKDOWN OF THE RECENT MARKET CORRECTION

For all of the worry of the recent stock market drop (we’ve taken more calls on it from worried investors than most comparable declines), the current stock market correction—so far—is a fairly typical one.  From here, the market could go up (with business growth) or down (due to either a slowdown in the economy or escalating trade and tariff concerns).

We start with a summary of our view for those who want to skip over the technical explanation which will follow:

SUMMARY

• The S&P 500 gained about 23% in 2024 (we use the S&P 500 Index as a proxy for the stock market throughout this discussion).  Part of this 23% climb was justified by growth and part of it was the stock market becoming overextended.
• While dramatic, the recent stock pullback is a fairly typical one so far—the type of which becomes probable when stock values climb too far, too fast.
• With a decline of just over 10% in a few weeks, the S&P 500 has reverted to a more typical level of historic valuations.  While stocks aren’t “cheap” yet, they are no longer overpriced, either.
• Concerns are legitimate over a possible economic slowdown, escalating trade wars, inflation which refuses to die, or some combination of these.  Future market performance is based on the outcome of a number of these unknowns.
• While we retain a somewhat aggressive outlook toward how investors should be allocated, it is not as aggressive as it was last year.

BREAKDOWN OF THE RECENT DECLINE

The S&P 500 started a steady decline in late February, dropping a total of about 10.4% from the peak to the bottom of the drop.  The decline was sharp enough that the index broke below its 200-day moving average (essentially a charted trajectory of the prices over the last 200 days).

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As is typical, the decline in stocks came with a spike in the CBOE Volatility Index, which surged for nearly a month from mid-February to Mid-March.  The volatility gauge nearly doubled in very short order.

However, since peaking on March 10^th, the volatility index has dropped about 85% of the way back to where it started.  Since then, the stock market has attempted to stage a comeback, regaining about 40% of what was lost over the last month.

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CAUSES OF THE RECENT DECLINE

The decline in the S&P 500 may have seemed more dramatic than it was because this was the first correction of 10% (or more) since 2023.  Things have been very tranquil.  A pullback is never inevitable and can’t be easily predicted, but they do often seem necessary with hindsight to pave the way for new growth.

However, crucially, to imagine that we were simply “due” for a pullback obscures the factors that go into it. After all, until the S&P 500 hit a breaking point, investors seemed perfectly happy to go along with elevated stock values.  It would be a mistake to pretend that the market corrected itself without a bit of external pressure.

If you want to boil it down to a sentence, the recent market sell-off was rooted in uncertainty. This can be seen in the dramatic spike in the United States “Economic Policy Uncertainty Index” which suddenly surged to an all-time high (even surpassing Covid-related peaks).

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While there are several worries in the market (and we won’t dissect any of them in full detail here), the most obvious culprit of uncertainty (and resulting stock pullback) is outstanding trade and tariff headlines.  In this, the culprit isn’t the policies themselves as much as the lack of clarity around them.  Said another way, the stock market can price in almost anything.  Uncertainty is when the stock market doesn’t know what to price in.  Recent tariff headlines, full of announcements, walk-backs, further escalations, delays in deadlines, and unclear requests (Canadian tariffs were about fentanyl … until they weren’t), couldn’t exemplify this better.  In our view, this is what triggered the recent sell-off (and surge in volatility).

There are also concerns regarding a potentially slowing economy and about remaining inflation being “stickier” than expected.  We decline to detail those here, not because they aren’t important for ongoing expectations, but because we don’t view either as being a major factor of the recent market sell-off.  Both, however, warrant future discussion at length as the “negative” argument is far from being priced into the market if it were to come true.

A HELPFUL CORRECTION

The first draft of this article described the recent market sell-off as a “healthy” correction, but that’s not quite the right sentiment.  Whatever the cause, so far it has been a helpful correction in bringing stock values back to more traditional levels.  Stocks had become overvalued, with costs outpacing earnings growth.

Thanks to the recent pullback, stocks are actually slightly cheaper than they were a year ago, which we will exemplify though a quick look at price-to-earnings ratios.  These numbers divide a company’s earnings into its stock price to create comparable ratios.  The numbers can be calculated using either a business’s current earnings or its expected future earnings (typically a projection of income one year from now).

The S&P 500 now has a current price-to-earnings ratio of 22.98, down from 23.83 one year ago.  Divided by future projected business earnings, the current level of 20.95 is not far out of line with a historical average during periods of sub-3% inflation.  This is roughly where this metric was last year (20.68) and means that the S&P 500 is back to the multiples of about a year ago.  The market has shed the portions of last year’s gains which represented unjustified multiple expansion, but it has retained the portion which can be justified by realized (or expected) growth in earnings.  From our vantage point today, the recent sell-off looks like a perfect example of a healthy correction, whatever the catalyst.

We believe that stocks are fairly valued today, but that the market could go up or down from here.  The “growth” side of the argument simply assumes that businesses continue to grow despite any headwinds (which, of course, tends to be true over time).  Additional stock declines could come, at least in the short-term, with escalating trade confrontations, a slowing economy, or “sticky” inflation.

I heard an analyst recently state, and I paraphrase, that, “We never really know anything in the stock market—pullbacks happen when we admit that to ourselves”.  I believe that also describes the coming months.  None of us have a crystal ball, but there are times in which it feels like we have less of one than others.  As such, while it is almost always a mistake to sell stocks because you “predict” market weakness, we have tweaked our portfolios recently to try to account for market uncertainty and slightly reduce volatility and implied risk.  There are ways to adapt portfolios without selling.

If you’re concerned about the economy or unsure how to invest, feel free to reach out to us.