Is a Market Blizzard Coming?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 16, 2014 1:47:00 PM

and tagged Investing

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market blizzardOnce again, the winds of market turbulence are starting to blow. Once again, barometers (and stock prices) are dropping. Once again, we wonder why we ever thought it was a good idea to invest in stocks.

We can’t predict the weather, but we can be pretty certain, year to year, that some seasons will be more troublesome than others. We know, for example, that winter brings blizzards to New England. Given that, if we get a blizzard warning, what do we do?

Do we sell the house at a loss and move south? Or do we stock up on food and batteries, check the generator, gas up the snowblower, and prepare to ride it out?

Time to hunker down and weather the storm

I get it: after a stretch of sunny weather, the cold air is brutal. But before we make any big changes in our portfolios, let’s think about why we’re invested in stocks in the first place.

We are in stocks because they benefit from a growing economy. As these figures show, the U.S. economy is on a clear path to recovery:

  • Over the past year, growth has accelerated significantly. The second quarter’s growth rate of 4.6 percent was the highest since 2011 (and before that, 2006).
  • Per the Challenger survey, layoffs are at a 14-year low, and hiring plans are at an all-time high.
  • Initial unemployment claims have been under 300,000 for four straight weeks—the first time that’s happened since April 2006.
  • The number of Americans receiving unemployment payments is 1.5 percent of the labor force—the lowest level since 2000.
  • The unemployment rate has fallen to the levels of 2004.
  • All of the key economic indicators I follow are giving the economy a green light.

We are in stocks because, over time, they have been the best income-creation engine available. When companies make money, investors make money. Right now, companies are making more money than ever before, and stock prices have reflected that.

Sometimes, of course, stock prices get ahead of themselves and have to step back a bit, and that’s exactly what is happening now. After climbing quite high, market valuations have adjusted to reflect more realistic expectations. An adjustment like the current one—or even one worse than this—is absolutely normal in market history.

What can we expect?  

The question, really, is whether the market will drop even more, and when stocks will recover. We can’t predict either, but we can look at history to provide some context. Over the past five years, we’ve seen two significant declines, each of which bottomed out at about a 15-percent loss. That seems like a reasonable worst-case scenario at the moment. 

This time, though, the U.S. economy is on more solid footing. This time, the problems come from elsewhere in the world, rather than here at home. This time, we’re much better positioned to ride out any turbulence, with less damage and a faster recovery.

If the market drops 10 percent, we need to see earnings growth of 10 percent, or an expansion in the price-earnings ratio of the same, to get back to where we were. Earnings are expected to grow that much in the next year or so, and, historically, P/E ratios have gone up with faster economic growth. Based on these factors, even if things get worse, the market might still be back to highs within a year or so.

Forecast: sound economic fundamentals should limit damage

There are no guarantees, of course, but the solid economy and U.S. profit picture can easily support values over time, limiting the damage of a short-term drawdown. It’s only when an overvalued market combines with a weak economy that we see really damaging declines, and that’s not the case right now. 

A serious market blizzard may or may not be coming. The fact is, for the real economy, this is more like an April storm. As anyone in the Northeast knows, April blizzards can be unpleasant, but they’re much less severe than February ones. No matter how much snow falls, the coming warmer weather should reverse the damage.

Now, where’s my snowblower?

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Tune in to CNBC's Power Lunch on Wednesday, February 26, between 1:45 and 3:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Check local listings for availability. 

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