US Equity Correction? Prepare, Don’t Panic

Political noise emanating from Washington has prompted fresh concerns that a US equity market correction may be looming. But have no fear: the market often takes a leg down, only to bounce back quickly.

US stocks have enjoyed a powerful rally since the election of Donald Trump as president in November. The S&P 500 Index advanced by 13.4% from the election through May 23, on hopes that the new administration’s policies—including tax cuts, deregulation and repatriation of corporate cash held overseas—would boost economic growth and earnings. Now, with the president facing major political challenges, investors are concerned that the optimism may have been premature.

GAUGING THE WARNING SIGNS

US equity valuations are one of the key concerns today. The S&P 500 is trading at a price/forward earnings ratio of 17.9×, which is relatively high in historical perspective. While these valuations are supported by strong profitability, investors are questioning whether margins can continue to improve as they have over the last few years. And volatility has been extremely low, until it spiked last Wednesday. These conditions, together with political uncertainty, suggest that stocks could be vulnerable to a change in sentiment.

But let’s put the economy and the market in perspective. It’s true that first-quarter GDP growth was disappointing as consumer spending slowed. Yet many positive trends, including low unemployment and upbeat business surveys, were in place well before the election and point to solid growth ahead. There are also encouraging growth signals in other parts of the world, in particular both Japan and Europe.

DRAWDOWNS ARE COMMON IN STRONG YEARS FOR STOCKS

Market trends also require context. At some point during 20 of the last 37 years, US equities have been hit by a peak-to-trough decline of at least 10% (Display). These episodes always trigger anxiety and make investors search for the exits. Yet, the bounceback is often very quick. Stocks have posted full-year declines in just six of those 20 years.