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Summary

  • Recent U.S. stock market weakness doesn’t appear to be accompanied by the usual bear market signals, in my view.
  • The pullback looks likely to be a “healthy” recalibration of prices.
  • I believe the current market weakness presents a buying opportunity, especially in deep-value-oriented investment strategies.

By Rick Golod

U.S. stocks retreated in July and have continued to waver in August. While no one can predict the stock market's movements for certain, I believe the probabilities point to a correction (a 10% drop), rather than a crash (a decline of 20% or more).

The main reasons I'm skeptical about a bear market include the following:

1. Corrections are temporary - Corrections are short-term interruptions within longer-term uptrends, whereas a bear market is a prolonged downturn. I believe the market's current pullback is likely to be short-lived because bull markets end in recessions, which are typically signaled by an inverted yield curve. Presently, I'm not seeing strong risk factors for either an economic downturn or yields on short-term rates moving above those of long-term rates. In fact, based on the July reading of the Institute for Supply Management (ISM) Manufacturing Index, recession looks two to three years away.1

2. Corrections are less painful - Definitions vary, but generally, a stock market correction is considered a drop of 10% to 20%, while a bear market falls even further and persists for a year or more. For example, history's two most recent crashes (2000 and 2008) each saw the market lose half its value, then take years to recover those losses.

This year, the market has been driven by both rising earnings and rising valuations - and I expect that to continue as a rising dollar, falling commodity prices and improving leading indicators bode well. According to one analysis, since 1985, when both earnings and valuations were up, market volatility was more subdued and the magnitude of corrections was smaller on average, compared to markets in which only one of the factors contributed to appreciation.2 Of course, past performance is no guarantee of future results.

3. Corrections present buying opportunities - Within any bull market, corrections are normal and inevitable. In fact, I consider them "healthy" at times, as they help to recalibrate prices after periods of strong appreciation. When prices have pulled back but fundamentals remain strong, the market's temporary weakness can provide an attractive buying opportunity.

Some areas of the market may likely experience larger declines than others during a correction. In my opinion, improvements in certain leading indicators suggest a more favorable outlook for value than growth stocks, especially for deep value managers overweight in the "hypercyclicals" (financials, technology, consumer discretionary, energy).3

Watching your equity portfolio's value decrease can be painful. But, trying to time the market's highs and lows could cause you to miss important gains in the market, setting you back from your investment goals. What you can do is stay diversified and focus on the long term. See my August commentary, Look for Opportunity in Uncertainty, for a more detailed discussion of the risks and potential rewards in these market conditions.

Sources

  1. Gluskin Sheff, Aug. 5, 2014
  2. Cornerstone Macro, July 29, 2014
  3. Bloomberg LP, June 30, 2014, and July 31, 2014; Cornerstone Macro, April 8, 2014

Important information

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

Diversification does not guarantee a profit or eliminate the risk of loss.

The S&P 500® Index is an unmanaged index considered representative of the U.S. stock market. The Institute for Supply Management (ISM) Manufacturing Index is a commonly cited gauge of manufacturing conditions based on surveys of more than 300 manufacturing firms conducted by the ISM. Price-earnings (P/E) ratio, also called multiple, is a common valuation metric for stocks that compares a stock's share price to its per-share earnings. Earnings per share (EPS) is a gauge of a company's profitability expressed as its earnings per share of outstanding common stock.

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Disclaimer: The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. The opinions expressed are those of the author(s), are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

All data provided by Invesco unless otherwise noted.

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Source: 3 Reasons This Correction Doesn't Resemble A Crash