On the face of it, that decline doesn’t seem to make much sense. But the unfortunate side effect of economic growth is that interest rates are likely to stay higher for longer—and that is just what the markets have started to realize. Interest rates stayed at almost 5 percent for the 10-year U.S. Treasury all this week and last, as markets priced in higher for longer. In turn, stock valuations, which move in the opposite direction of rates, dropped from around 20 times next year’s earnings to around 18 times. That’s a big shift and explains the market pullback.
What does this mean going forward? The good news is that, at least for the moment, rates seem to have stabilized, which should limit any further valuation declines in the short term. Over the longer term, the valuation adjustment should be offset by earnings growth, which is still expected to be strong over the next several quarters.
With the economy still healthy and with earnings expected to grow, the current repricing looks like an adjustment rather than something worse. No one likes a market pullback. But with a solid economic foundation in place, we have some cushion here. The current decline, at around 10 percent, is quite normal. In fact, it’s something we typically see around once a year. Even if it gets somewhat worse, that would also be normal—and something we have seen many times before.
In other words, while this wasn’t a great week for markets, this is a normal pullback that makes sense given financial conditions. From what we see right now, prospects for the market over time are still positive. And that is a good thing to remember as we finish the week.
Have a great weekend!