We had nasty stock market corrections in the middle of 2010, 2011 and 2012 caused by political uncertainty about Europe's debt.
In times of market declines, it is good to remind ourselves the difference between a correction and a bear market.
From a technical point of view, correction is when the market falls short of a 20% decline; more than 20% drop is a bear market. From a fundamental perspective, during corrections, investors expect future earnings to fall so they put lower valuation multiples (P/Es) on the current earnings. If the earnings do not fall or continue to rise, P/E rebounds and bull market resumes. If earnings do fall, the P/Es may drop further resulting in a bear market.
So corrections are panic attacks that aren't confirmed by the fundamental earnings trend. No wonder the stock market's behavior is often compared to that of a manic depressive.
As you can see in the below chart, S&P 500 index (red) market's volatility since early 2009 bottom is attributable almost entirely to the volatility in the P/E. The USA earnings are in a clear sharp uptrend and that is why the corrections did not turn into a bear market and an economic recession. The blue lines represent S&P 500 index value at theoretical constant P/Es ranging from 10 to 15 times.
If the investors were more optimistic about the future and put P/E multiple of 15 on the recent earnings, the S&P 500 index would be much higher at around the 1700 level.
What caused the negative P/E sentiment?
Markets lacked confidence because of the political uncertainty surrounding the three issues:
- European periphery sovereign debt problems
- Slowing China
- Looming USA Fiscal Cliff
All three issues can be resolved, given sufficient time and political will. The short-term focused markets will fluctuate on the way until the long term picture becomes clear.
Germany will have to underwrite Europe
Resolution of the European periphery sovereign debt problems requires evolution of the political will to allow the structural changes. In previous writings, I stated that every crisis brings the eurozone countries to a closer banking, monetary and fiscal union. More centralization should enable use of the available powerful macro tools: joint bank guarantees & rescues, joint-eurobonds, low interest rates for all countries, and badly needed coordinated fiscal stimulus for whole of Europe.
Germany is an obstacle on the road to the more integrated Europe. It's society represented by Merkel failed so far to fully appreciate their dependence on the prosperity in the rest of the eurozone. The graph of German industrial production synchronized with the rest of Europe illustrates the close interdependency. If periphery economies fall Germany will fall with it; Germany does not have much choice but to underwrite the common Europe to promote growth or the whole euro project built since the end of WWII will collapse.
Source: FactSet, German Federal Statistics Office, Eurostat, Charles Schwab. June 12, 2012.
China's growth story should continue under new leaders
China is slowing but still growing strongly at around 8% per annum. The growth has been predominantly driven by domestic investments. Trade surplus was negligible.
China has tools to maintain healthy growth by easing lending rates, resuming investments and increasing domestic consumption. The recent slowdown was intentional. They took a conscious decision in 2010-11 to tighten lending rates as The Economist's charts show.
Click to enlarge
A new incoming Chinese leadership can easily loosen up the policy to mark the beginning of their reign with resumption of strong growth.
Looming fallout from the USA "Fiscal Cliff"
The fast approaching November 2012 USA Presidential Elections call for political "sweeteners." This is the best time for politicians to announce economic programs that will be popular with the voters - programs that will create jobs and restore a sense of wealth and optimism about the future.
Any substantial new fiscal and monetary stimulus would be most welcomed by the stock market conscious of the Fiscal Cliff at the end of 2012 when many of the current programs run out. Recent extension of the Twist program followed by Quantitative Easing in the USA and Europe signals central banks' accommodative intentions.
Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article.