Why The Market Has Plunged And What You Should Do

| About: SPDR S&P (SPY)

Summary

The stock market is having a rough start this year.

The real reason behind the plunge is not the Chinese economy. It is the cycle of higher interest rates, which just started.

However, investors should not miss the big picture. This secular bull market still has much room to run.

Down The market has started on a pronouncedly negative tone this year. The S&P 500 (NYSEARCA:SPY) has already lost 6% in 2016 while it has not recorded even one meaningful positive session in the last 10 trading days. While the headlines are full of negative views on the Chinese economy, investors should pinpoint the real cause of the plunge of the market in order to make the right decisions for their portfolio.

First of all, it is true that the Chinese economy grows every year at a decelerating rate. Therefore, while it grew at an almost 8% annual pace during 2012-2014, it grew by about 7% in 2015 and is expected to grow by about 6.7% this year.

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However, as China has become the second largest economy in the world, it is only natural that it will keep growing at a progressively lower rate, as this is the law of large numbers in economy. Moreover, there has been no negative revision in its expected growth rate recently so the plunge of S&P cannot be attributed to the deceleration of China. Even if China were to markedly decelerate, a report from Goldman Sachs states that every 1% decrease in Chinese GDP causes a drop of only 0.06% in the US output. Therefore, the concerns over a domino effect beginning from China are completely overblown.

The real reason for the negative sentiment of the market lately is the cycle of interest rate hikes, which just started after 9 years. As near-term bonds have been offering almost zero yields while long-term bonds have been offering minimal yields, stocks have been clearly the best choice in the last 7 years. This is a significant factor of the ongoing 7-year bull market. However, as the Fed recently stated that it expected to raise interest rates by about 1% per year from now on, it is evident that the gap between stocks and bonds will start closing and at some point bonds may become even more attractive than stocks. Therefore, it is only natural that the market has lost some ground, particularly given its recent fully valued status.

Some investors could claim that it is too early in the cycle of interest rates to talk about a shift in the attractiveness of bonds. While this is true, these investors should realize that the market has started to discount future expectations to the extreme in the last few years. For instance, the dollar enjoyed a remarkable 30% rally while the interest rates were zero, long before the first hike was announced by Fed. Even more impressively, the dollar has failed to post new highs despite the recent hike of interest rates and the plentiful, recently announced upcoming hikes in the next few years, while Europe will keep running its QE program. To make a long story short, the market has become so efficient in the last few years that it prices future expectations in the stock prices to the extreme. Consequently, it has become hard to determine what portion of the future hikes of interest rates has been priced into stocks.

Nevertheless, the valuation of the stock market has returned to fairly reasonable levels after the recent plunge. More specifically, S&P is now trading at a forward P/E=16, which does not indicate overvaluation by any means. To be sure, S&P has historically traded at an average P/E=17. Therefore, as the earnings yield of the market (the inverse of P/E) is now about 6%, the valuation of the market is now fairly reasonable even for much higher interest rates, in the range 2%-3%. This means that the market has already priced many future hikes of interest rates into the stocks and hence the current valuation of S&P is not stretched by any means.

All in all, investors should realize that the recent plunge of the market has resulted from the cycle of interest rate hikes, which just started, not China. In addition, this dive has brought the valuation of S&P to reasonable levels so investors should not be scared and driven out of the market. Of course a bear market can arise at any moment but it is almost impossible to time it. Instead it is much more profitable to select some stocks with strong growth aspects and minimal debt so that they will not be hurt by higher interest rates.

In any case investors should not miss the big picture; the market is in a secular, not cyclical, bull market. According to the historic behavior of the stock market for more than one century, the US stock market may trade in a range for 10-20 years but then always runs a secular bull market for another 10-20 years. S&P traded in a range since from 1997 to 2013 and has broken above that range since then.

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As history has taught us, this is a signal of a secular bull market, which will take the index to progressively new highs, for many years to come. While the pundits expect a bear market after a 7-year bull market, the secular bull markets last much longer than anyone expects. To be sure, most bearish investors have been calling the end of the current bull market since its beginning and have thus missed one of the greatest rallies ever.

The secular bull markets mainly result from the great technological progress, which takes the prosperity level and the corporate profits to a new all-time high. For instance, the new oil drilling technique, which has caused the supply glut in the oil market, was inconceivable a few years ago. Thanks to this technique, the energy cost has diminished for many companies while the gasoline expense has plunged for consumers. There have also been great advances in the ease and speed of transactions and the efficiency in every single aspect of corporations (e.g. inventory handling), which has resulted in a shift in corporate profits and prosperity of consumers. All these factors (and others) are leading the ongoing secular bull market and investors should not miss this big picture.

Nevertheless, as this bull market is soon celebrating its 7th anniversary, it is becoming more and more a stock picker's game, i.e., choosing the right stocks is more critical than in previous years. Therefore, investors should perform their due diligence to carefully select the most promising stocks and then stay the course and not be scared out of the market by the surrounding noise.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.