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The stock market’s severe drop: Normal pullback or an ominous sign?

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Traders on the floor of the New York Stock Exchange on Dec. 6, 2018.
(Spencer Platt/Getty Images)

Last week, it felt like the bottom dropped out of the stock market.

The blue-chip Dow Jones industrial average plunged 4.5% for the week, ending with a 559-point rout Friday that left the index in negative territory for the year.

The benchmark Standard & Poor’s 500 index has fallen into a “correction,” meaning it’s off more than 10% from its peak reached Sept. 20.

And once-highflying tech stocks have suffered some of the heaviest selling, with Apple, Facebook and Google parent Alphabet all ending last week showing losses for the year — driving the Nasdaq composite index into a correction too.

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So is this it — the end of the decade-long bull market? Or is it the sort of normal, healthy pullback that often follows such a strong run-up?

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(Los Angeles Times)

“Everyone is trying to figure that out,” said Sam Stovall, chief investment strategist at CFRA Research, though he’s among those arguing that stocks are going through a typical retreat after lengthy gains, as they often have throughout history.

Obscuring any clarity for both professional money managers and millions of Americans with 401(k)s and other retirement accounts are conflicting trends that are keeping downward pressure on stock prices and sparking volatile trading.

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They include the U.S.-China tariffs and trade battle, tumbling oil prices, the Federal Reserve raising interest rates, President Trump’s mercurial bursts on Twitter, declining growth in corporate profits — and, ultimately, fears that the nine-year economic expansion is long in the tooth and ready for a cyclical contraction.

Let’s start with some context for what’s happening this time.

First, this fall’s pullback is nowhere near as severe — at least not yet — as some of the major busts of the last two decades. The benchmark S&P 500 plunged nearly 57% during the 2008-09 financial crisis and nearly 49% in the dot-com crash of 2000-02. Those were bear markets, or drops of 20% or more from their previous highs.

Second, the triple-digit swings in the Dow industrials that garner big headlines — while truly unnerving a decade ago — are now more common because the market has climbed so high since then, and the declines are less severe on a percentage basis. By contrast, when the Dow plummeted 508 points on Oct. 19, 1987, for instance, it was a 22.6% loss — the largest single-day percentage drop on record.

In addition, the stock market reached its highest levels in history only a few months ago, and that was after the market soared in 2017, when the S&P 500 gained nearly 20% and the Nasdaq composite shot up 28%. As a result, it’s not surprising that investors would be willing to sell and capture those profits when signs of trouble surface.

Last year also was unusual for the dearth of volatility that is now again commonplace.

“We had an incredible amount of investor optimism coming out of the election in 2016,” said Peter Heilbron, senior investment officer of Northern Trust Wealth Management. “Last year was the anomaly, not this year. A year like this is much more normal for the market than we had in 2017.”

That’s not to discount the pain investors have felt in recent months or how dangerous the trade and economic threats are to the market. The S&P 500 lost 6.9% in October alone, its biggest monthly decline in seven years.

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And last week the yield on five-year Treasury bonds fell below the yield for two-year bonds for the first time since 2007 — a so-called inverted yield curve that is typically seen as a gauge of higher recession risk. (Investors typically are rewarded with higher yields for locking up their money longer, not the other way around.)

Yet stocks also are on pace to end the year with minor changes. Even after last week’s dreary showing, the Dow and S&P 500 were down only 1.3% and 1.5% for the year, respectively, and the Nasdaq composite index was up 1%.

Investors also pay attention to how stock prices compare with the underlying corporate earnings for those stocks. If prices get too far ahead of the earnings growth, the stocks might be too “rich” or pricey and vulnerable to a sell-off. Conversely, if prices match or lag behind earnings growth, it might be a buy.

Early this year, the S&P 500 was trading at a price-to-earnings ratio of 18.7 times the expected average earnings of the S&P component companies for the next 12 months, according to FactSet.

Now, with the market having tumbled, that forward P/E multiple has dropped to 15.44, which is about average. “They’re in line with historical norms,” Heilbron said.

So the next question is: What’s the outlook for corporate earnings going forward? And the consensus seems to be that they’re slowing — albeit from a blistering pace. Stovall said that at the start of this year Wall Street expected earnings growth of 11.5% for 2018.

“It looks like we’re going to see twice that amount, with average earnings [growth] for the S&P of 23%,” — profits, he said, that were partly turbocharged by the drop in federal corporate tax rates from the GOP tax cuts. But next year he projects that growth will slow to 7.5%.

“Investors are like hyperactive first-graders playing musical chairs and trying to anticipate when the music will stop,” Stovall said. “As a result, they’re thinking that earnings growth slowing is something we should worry about or extrapolate into a possible recession. We think it’s too early for that.”

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Mark Esposito, founder of Esposito Securities in Dallas, thinks otherwise, partly because of the rise in interest rates.

Fed monetary policy makers have raised the central bank’s key short-term interest rate three times this year and are widely expected to inch it up another 0.25 of a percentage point to a target range of 2.25% to 2.5% when they meet later this month.

It would be the fourth hike this year, and in their last forecast, in September, Fed officials indicated there would be three more such hikes in 2019 — though they have recently given signs they could back off if the economic data warrants.

“The Fed was way too aggressive in their take on raising rates,” which is translating into a scenario in which “a recession will come in the next six to 24 months,” Esposito said. Facing that threat, “I think the market’s fairly valued,” he said.

Speculation abounds that the U.S. economy will slow.

The economy grew at a 4.2% annual rate in the second quarter, the fastest since 2014. But the rate slowed to 3.5% in the third quarter as the initial stimulus from the tax cuts that took effect this year faded.

The UCLA Anderson School of Management last week predicted that the nation’s inflation-adjusted gross domestic product, or GDP, would slow from 3% this year to 2% in 2019 and 1% in 2020.

There’s also the fear that the Trump administration will follow through on raising tariffs further against imported Chinese goods, thus further disrupting trade and economic growth, if the White House and China can’t reach agreement in their trade talks.

Nonetheless, “stock market fundamentals remain generally favorable” and many of the economic concerns “may largely be reflected in lower stock prices,” said John Lynch, chief investment strategist at LPL Financial, in a note to clients.

“We may be witnessing enough fear today [in the market] to set the stage for the next rally,” Lynch said. “We still believe the S&P 500 is trading below fair value.”

Other things could set the stage for a rebound in the coming months. The United States could strike a trade deal with China. The Fed could slow its pace of interest-rate hikes. The U.S. economy and corporate profits could keep showing healthy growth.

Slower earnings growth “doesn’t mean it portends negative returns in the market,” Heilbron said. “High single-digit earnings growth is still an attractive profile for corporate America,” he said.

Heilbron also thinks the bull market in stocks is not over, and some others agreed, noting that employment, earnings and the economy are still growing while inflation and interest rates remain low by historical standards.

Brad McMillan, chief investment officer for Commonwealth Financial Network, agreed that the signs of a looming recession “simply don’t seem to be there.”

“The economy is slowing, but it is still growing,” McMillan said in a note to clients. “Although corporate earnings growth will likely moderate next year, expectations are that it will still be strong. In other words, things are not as good as they were but they are still not bad at all.”

The market’s pullback thus raises the question of whether stocks’ lower prices offer an entry point, an attractive dip at which to buy stocks ahead of the next rebound. That’s what investors did this spring, after stocks dropped back from a rally in January.

“We’re probably getting pretty close to that” point even if “there could be more weakness ahead,” Stovall said.

“I would say, yes, you could pick up some attractively valued, high-quality stocks now,” but given the swings like Wall Street saw last week, “I don’t think now is the time to be backing up the truck,” he said.

Times staff writer James Rufus Koren contributed to this article.

james.peltz@latimes.com

Twitter: @PeltzLATimes


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