I attribute every stock market correction or bear market to one of two reasons. Either valuations were too high and needed to correct to reconnect valuations with reality, or there could be a real-world problem (pandemic, war, recession, taxes, regulation, rising interest rates, etc.) that creates concern about the value of future cash flows.
In my last quarterly update from July 1, I observed, “Near term, the market does not seem to have a lot of upside until we have a Covid-19 vaccine.” Now we know how bad I missed on that prediction. The S&P 500 rallied 14.9% from July 1 to September 2, with the help of the best August returns in about 30 years.
Using the Morningstar Market Valuation chart, the market was about 1% overvalued on July 1. Earnings in July and August were strong, and analysts’ estimates moved higher. Still, by September 2, the chart indicated that the market was overvalued by 8%. The greater the variance of the market from fair value, the more likely the market price is to correct to the analysts’ more rational view. That is what just happened. As of the close on September 8, the market was back to 1% over fair value. However, the S&P 500 was still 6.9% higher than on July 1, when the quarter started. The difference is that earnings exceeded analysts’ estimates and fair value estimates were adjusted accordingly.
What does this mean? It means we need to buckle up for the ride, considering all the reasons to run for the hills. Volatility will not hurt you. As I described, that uncomfortable market experience you just had made you better off. Today the S&P 500 tacked on another 2.01% gain to rebound from part of the correction. That puts us about 3% over fair value, but well within the normal range. For reference, I usually cite 10% above or below fair value as a level to make tactical allocation adjustments, sometimes called market timing, because I think risk becomes materially asymmetric.
Let’s hope the 3rd quarter ends on a good note.
Investing involves risk, including loss of principal. Past performance does not guarantee future returns. Sources include Yahoo Finance and Morningstar.