We knew this was coming eventually.
After months of premature warnings that the sky was falling, the long-anticipated market correction has finally arrived. The boy is no longer crying wolf on Wall Street.
The numbers have been ugly for weeks. Today, things may have reached a tipping point … at least we hope this is the tipping point.
Just look at this chart of the past month:
Since closing at an all-time high of 2,011 on Sept. 18, the S&P 500 has plummeted more than 8.5%. We’re on the cusp of the first true correction (10%) since July 2011. Until this week, no pullback in the last two years had exceeded 6%.
(I will pause here to give you a chance to take a big gulp of Maalox …. ….. …… Feel better? Good.)
Now, let’s get on to answering the important question: What does it all mean?
Is Ebola panic spilling onto Wall Street? Is it the Fed pulling the plug on QE3? Is Europe’s threat of an unprecedented triple-dip recession weighing on U.S. markets?
Certainly those factors, and others (Russia-Ukraine, ISIS, uneven U.S. GDP growth, etc.) aren’t helping. But … no.
The real reason for this sudden crash? It’s simple: stocks were overbought. Or more accurately, the overwhelming impression on Wall Street was that stocks had become overbought.
Entering the week, stocks were trading at 15 times forward 12-month earnings estimates, higher than both the five- (13.5) and 10-year (14.1) averages. However, as the bulls would quickly point out, that ratio still trailed the 15-year average of 15.8. It also trailed the ultra-high forward P/E ratios around the turn of the century, which were routinely above 20.
Nevertheless, if enough people – particularly people with very public platforms such as CNBC and Yahoo! Finance – say that stocks are overbought … eventually, investors start to believe it and it becomes a domino effect.
It might be a while before that last domino falls. Stocks may not stop at a 10% correction. They could fall as much as 20%.
That’s the bad news. The good news is that this is likely a short-term correction.
Since the 2008-09 recession, both times stocks have fallen more than 10%, they’ve taken less than six months to bounce back above their pre-correction level. Take a look at this five-year chart:
Unlike Europe, we’re not headed for another recession.
Unemployment is below 6% for the first time in more than six years. Corporate earnings continue to grow. The big banks are no longer under water. We’re not headed for a two-year crash like we saw in 2007 or 2002. Eventually, this pullback will be a good thing, allowing many of you to buy stocks that aren’t already trading at all-time highs.
But this correction is real. And it shouldn’t be a surprise.
This article is brought to you courtesy of Chris Preston from Wyatt Research.