The market sell-off continues, and as the slide gets more severe, we have to ask ourselves, once more, how worried we should be.
I’ve written over the past couple of days that it's not time to panic, and I still believe that's true. But it appears there may be more short-term damage than I initially thought. Now, the question is, how much worse might it get, and what does that mean for us as investors?
A Break In Confidence?
First, let’s consider why things might get worse. The basic economics remain sound, and a weak retail sales report this morning (a backward-looking indicator) was offset by an increase in consumer confidence, which is forward looking. Industrial production declined, but that’s not a surprise given other data we already had. Overall, the economic news isn’t grounds for today’s decline.
The reason, then, must be that investor confidence is cracking, and fear is driving people to pull money out of the market. One proxy for this is technical factors. The S&P 500 has broken both its 200- and 400-day moving averages, which often suggests further weakness ahead, and is flirting with the lows of the last pullback, in August. Should the market break below that level, technical traders might well start selling, putting even more downward pressure on stock prices.
Right now, the S&P 500 is down about 13 percent—a normal pullback, in historical context. From a forward valuation perspective, we're at about 14.75x forward earnings, which takes us back to levels of mid-2013. So far, so normal.
There is, however, a clear possibility for confidence to break even further. Should that happen, as I discussed the other day, a 15-percent decline would bring us to 1,815, and a 20-percent decline would take us to 1,708, or to valuation levels of 14.3x and 13.5x, respectively.
What A Bear Market Might Look Like
Looking at what seems to be scaring the market today, I'm reminded of the 1998 Asian financial crisis and the 2011 Greek/European crisis. In both cases, the markets dropped by about 19 percent. For the moment, let’s take a 20-percent decline, consistent with those events, and analyze what that might look like. Assume, in other words, that declining confidence and rising fear bring us to a bear market. What would that mean?
In yesterday's discussion, we made a clear distinction between recession-driven bear markets and confidence-driven ones. Let’s clarify that a bit further. In a recession, companies will earn (and, therefore, be worth) less. At the same time, scared investors will be willing to pay less for any stream of earnings. The drop in prices reflects this double whammy, and any recovery has to come from (1) an improvement in companies’ earnings prospects, and (2) a recovery in investor confidence. On average, this takes about 30 months.