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Relax—It's Just a Correction
02/11/2010 2:18 pm EST
Something has been wrong with the markets in 2010.
Since hitting its post-crash high of 10,725.43 on January 19th, the Dow Jones Industrial Average has lost more than 6%. The Standard & Poor’s 500 and Nasdaq Composite index are both down more than 7%.
High-flying emerging markets are off more: Shanghai has tumbled 10.7% from its peak, India is off 10%, and Brazil has slid 8%.
And that’s despite stronger gross domestic product growth in both the US and China, a decline in the official US unemployment rate, and terrific earnings reports from major companies.
The purported reason for the sell-off: the debt crisis in Greece, which has driven the euro down to multi-month lows against the US dollar and brought flutters of fear to markets that had gone nowhere but up. It was a stark reminder that the global financial system is far from healed after the crisis of 2007-2009.
On Thursday, leaders of the European Union struck a deal to “solve” the Greek crisis—more like a quick fix—in which the euro zone’s stronger countries, such as Germany and France, may offer Greece loans or guarantees if it behaves and reduces its deficit.
But I think the Greek crisis was just a pretext for a long-needed sell-off in markets that had gone ten months without a significant correction.
I have no idea how deep this correction will get—or how much juice the markets have left once it’s over. But based on all the historical evidence I’ve seen, a correction it is, not the end of the rally.
Because quite simply, we were due.
Valuations were pretty high—the Standard & Poor’s 500 index was changing hands at more than 20x earnings, above its long-term average.
And then there’s the weight of history: We’ve been here before.
“Ned Davis Research reports that the odds of a 10% stock market correction, based on similar periods after the end of a recession and after such a big rally, is very high, estimated at 77%, based on historical market patterns in recoveries,” writes Janet Brown, editor of NoLoad Fund*X, in MoneyShow.com’s Gurus’ Views and Strategies.
Davis, based in Venice, Fla., also recently found that “market declines of more than 10% are common in the six to 18 months following a recession's end.”
If the recession officially ended last summer, as some economists maintain, then we’re right in the ballpark for that.
And another market-data maven, Birinyi Associates of Westport, Conn., compared this market to the 1982 bull, when a huge gain the first year “was followed by a 9% decline over the next 12 months, after which the bull market picked up steam again,” The Wall Street Journal reported. Something similar happened in 2003-2004.
Whether this market is comparable to 1982’s or not—I don’t think it is—the point is that this kind of a correction is quite normal and to be expected.
In fact, one of my big predictions for 2010 called for “a financial mini-crisis or two that re-ignite investors’ fears.”
“These mini-crises may turn out to be worse than Dubai, but nowhere near as bad as the fall of Lehman Brothers,” I wrote. “The sell-offs they trigger would be more like corrections than a second bear market.”
This correction could get even deeper.
“According to Morgan Stanley's European equity strategist Teun Draaisma, history's big ‘relief rallies’ average about 70 percent—about the rebound that stock markets have had—and this is followed by a 25 percent ‘correction,’ as part of the ongoing bear market that typically follows a big shock,” writes John Authers in the Financial Times.
That would get us back down to about Dow 8,000, which I don’t expect, barring a serious economic shock or a more severe financial crisis than that of Greece.
But I also don’t think there’s much more left in this bull, which has acted like a live-fast-die-young rock n’ roller. The economy will continue to improve, but unemployment will remain stubbornly high and there’s so much debt hanging over consumers and governments that it’s hard to see what would keep the fires burning.
The bull market of the 2000s was propelled by ridiculously low interest rates and lax lending practices that ignited a housing and spending boom. Add two wars, two mammoth tax cuts, and unfunded government spending and you had all you needed to inflate a bubble. Only now that it’s popped do we see how empty it all was.
We couldn’t do the same thing now if we wanted to. The heat is on to cut spending and raise revenues. Bank bailouts and economic-stimulus plans have left governments throughout the developed world grappling with World War II-level debt loads, and newly frugal consumers simply can’t shop ‘till they drop, because many of them have dropped already. Businesses are uneasy about new regulations that may be coming down the pike.
Those are the fundamental reasons I believe we’re still in a long-term bear market for stocks.
Yes, we’ll see a cyclical economic recovery, and maybe half of the market’s big move reflects that. (The other half is just relief the whole system didn’t come crashing down around our ears.)
And yes, the market will rally again. But unless something fundamental changes, I’m pretty sure the Dow won’t get near its October 2007 closing high above 14,000 any time soon.
For most of us, that means we’ll stay invested in stocks based on our age and risk tolerance and will put extra money into the market only as part of a solid investment plan.
But I wouldn’t throw extra money at this moving train—even if it looks like it’s leaving the station—because it’s winding its way through some very treacherous terrain indeed.
Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own.
Correction: An earlier version of this column said the Dow Jones Industrial Average hit its all-time high above 14,000 in October 2009. It was actually in October 2007, and the text has been updated to reflect that.
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