Some Perspective on the Stock Market

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 8, 2014 4:14:00 PM

and tagged Investing

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stock marketYesterday was a bad day for the stock market, which dropped sharply on fears about European growth. So they say, anyway.

Pinpointing a single reason for market moves has always seemed misguided to me, when you think about all the factors behind any investment decision. Even so, taking it at face value, what should we make of European growth and yesterday’s market decline?

The total decline for the S&P 500 is roughly about 4 percent so far. But is attributing all of this to Europe reasonable? Given Europe’s place in the world’s economy, it doesn’t seem that far out of line. You could argue that this is a rational response to high-level economic developments.

What will U.S. growth mean for the markets?

If that’s the case, though, you also have to consider the economic effect on the markets from increasing growth here in the U.S. I gave a presentation today on why I expect growth to pick up over the next 12 months or so, and the effect that higher growth would have on the stock market, which I’ll write about later this week. 

Briefly, stock market valuations tend to be correlated with the level of economic growth. As things get better, investors will pay more for any given level of earnings for stocks. When you combine this with actual earnings growth, you have a strong fundamental support under share prices.

Of course, this doesn’t mean we won’t get corrections, even big ones. Regular readers know that I believe the market is currently very overvalued, and I haven’t changed my mind. But I also believe that now, and for the near to medium term, there are powerful forces at play that should support the market.

Right now, we are in the midst of a decline, which could get worse. You can argue that this kind of a correction is rational and healthy, and that it reconnects stock prices with economic fundamentals—and I would agree with you. At the same time, though, those improving fundamentals are moving the reasonable valuation level up, making any decline likely to be smaller and shorter lived.

I can’t, unfortunately, predict the market. Further volatility is quite possible, even probable. As we plan for that, though, we should also be aware that positive factors exist and are likely to strengthen in the future, acting as a cushion over the longer term.

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