U.S. stock markets have performed exceedingly well dating back to late March 2020, in the early stages of the COVID-19 pandemic. At that time, the Standard & Poor’s 500 stock index, a benchmark of large-cap U.S. stock performance, declined more than 33 percent in about one month. Since then, the index has recovered in spectacular fashion, actually doubling in value by mid-August, 2021 from its low in March, 2020.
With such a dramatic recovery in a short span of time, some investors are concerned that the stock market may face increased risks of another significant downturn in the near future. It’s purely speculative to forecast when a market correction may occur over any short period of time. History has shown that it’s difficult to time major swings in the market, whether higher or lower. The question, however, is worth considering based on what’s known today of how the market is valued and in what way the underlying economy may impact investor actions.
What triggers market corrections
Market downturns, like what occurred in early 2020, can be triggered by different events. Explanations are typically easier to come by after the fact. Of the major bear markets that have taken place in recent times, the driving factors that led to the decline have varied.
For example, in early 2000, an extended bear market began that persisted until early 2003, after a long-lasting bull market. The most notable driver of the significant setback for equity prices was the bursting of a stock market “bubble” in prices for technology stocks, particularly some early-stage dot-com companies.
The 2007 to 2009 bear market was driven in large part by a surge in home prices that proved to be unsustainable. Too many property owners were highly leveraged, and not in a secure financial position to sustain the mortgages they’d obtained. This easy credit environment created problems throughout the financial system that required significant government intervention.
In February and March 2020, investors were just beginning to come to grips with the reality of the COVID-19 pandemic. Concerns about the unknown ramifications for the economy caused investors to temporarily lose confidence in stocks. Of course, that downturn was short-lived, and those who remained invested in stocks have prospered since.
An economic rescue mission
Significant fiscal and monetary intervention drove the turnaround in stocks that began in 2020. The monetary intervention came from the Federal Reserve (and other central banks around the world). They cut short-term interest rates to near zero percent and provided significant liquidity, particularly to fixed income markets. At the same time, the U.S. government passed a series of COVID relief bills that put several trillion dollars’ worth of government money to work in the economy. This came in a variety of forms, including direct payments to individuals, enhanced unemployment benefits for those who lost work during the pandemic, and financial support for struggling businesses.
This assistance buoyed investor sentiment and help initiate and a new bull market for stocks. “This was important because in 2020, most companies saw earnings and profits decline, so investors put their focus on efforts to keep the economy moving,” says Rob Haworth, senior investment strategy director at U.S. Bank. “That helped jumpstart the recovery.” Since then, the economy has generated strong growth, boosting corporate profits and leading to further gains in stock prices.
Benefiting from favorable fundamentals
Over the opening three months of 2021, the U.S. economy, as measured by Gross Domestic Product (GDP), grew at an annualized rate of 6.3 percent, according to the U.S. Bureau of Economic Analysis. The trend continued in the second quarter, with the economy growing at an annualized rate of 6.6 percent. “The market’s strong performance in 2021 is driven by the fundamentals – rising earnings and faster growth,” says Haworth. While valuations are modestly elevated, he believes that given the positive economic environment, stock prices don’t yet appear to be overextended.
An important measure of whether stocks are getting too “expensive” is to consider their valuations compared to earnings expectations. Haworth says while stock valuations today are above average, they are not unreasonable. “This is not a situation like the technology market bubble of 2000 where valuations had skyrocketed,” he suggests. “And it’s important to keep in mind that with interest rates on 10-year U.S. Treasuries still below two percent, stock prices remain quite reasonable relative to competing options.” Haworth believes unless current market sentiment or underlying fundamental factors change, valuations like what we’re seeing today are sustainable. “If interest rates suddenly moved higher, stock investors might be more reluctant to bid up stock prices because the value of future earnings will look less attractive versus bonds that pay more competitive yields.” But Haworth notes that isn’t a concern at this point.
Eric Freedman, chief investment officer at U.S. Bank, expects that over time, the rate of economic growth will slow. That could potentially make it difficult for companies to continue to grow their profits to the degree markets are projecting that into stock prices today. Even in a slower growth environment, Freedman believes U.S. stocks remain well positioned compared to other parts of the investment markets.
Risk factors that bear watching
What are other risk factors that could lead to a market correction in the coming months?
- Inflation. “Inflation concerns may be at the top of the list,” says Freedman. “While some investors worry about a persistent inflationary pickup as a significant concern, we don’t yet see inflation as a durable trend.”
Ongoing economic growth may be the key to how the market reacts should inflation become a bigger issue. “What would be most concerning is a period where inflation rises but economic growth becomes stagnant,” says Freedman. “That’s a situation the Fed wants to avoid.” In such an environment, according to Freedman, the Fed would be forced to raise interest rates to stem the inflation surge at the same time the economy is struggling, which could delay any economic recovery.
More likely, says Freedman, is that if inflation concerns require it, the Fed would take incremental steps to tighten monetary policy. The first step is to cut back on its purchases of bonds. Currently, the Fed is purchasing about $120 billion in bonds per month to help maintain liquidity in the market and keep interest rates lower. Federal Reserve chairman Jerome Powell has indicated that the Fed may begin to scale back its bond-buying activity by the end of 2021, with the potential of total curtailment of bond buying by mid-2022. At the same time, some Federal Open Market Committee members indicate that the Fed may begin raising short-term interest rates as early as 2022, rather than 2023 which is the Fed’s previous guidance.
- Real estate. One prominent area of the economy where prices rose significantly is the housing market. This has led to some speculation that another housing market bubble, similar to what occurred in 2007, could be on the horizon. However, a major distinguishing factor between that period and today is that stricter mortgage underwriting processes are being observed by most lenders. This should help limit the risk of the kind of surge in foreclosures and the resulting financial fallout that followed in 2007 and 2008. In recent months, it appears the flurry of activity in home sales has tapered off.
- COVID-19. Although great strides were made in tamping down the COVID-19 pandemic, the rise of the Delta variant over the summer proved that the issue is not yet behind us. The vaccine rollout in the U.S. gained momentum earlier in the year. Progress slowed after that, but in late summer, vaccination rates began to pick up again. President Joe Biden recently announced new vaccine requirements for federal workers and those employed by private firms with 100 or more employees in an effort to slow the infection rate in the U.S. Nevertheless, recent events indicate that the pandemic is far from over. Its potential future economic impact is a factor that investors will want to watch as well.
Keep a proper perspective
It’s important to remember that frequent corrections in a market are a normal event. In certain situations, such as what occurred in February and March of 2020, market drops can be more dramatic but also can be quickly overcome.
“If you’re concerned about where the markets stand today, it may be time to assess your risk tolerance and potentially reallocate assets to reduce your portfolio’s exposure to stocks,” says Haworth. “But keep in mind that we’re likely to experience market ups and downs regardless, and over time, markets have shown an ability to recover.”
Check in with your wealth planning professional to make sure you’re comfortable with your current investments and that your portfolio remains consistent with your long-term financial goals.
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