The good news is that drops in valuations tend not to last long, especially big ones like the one this year. In a report last week, UBS strategist Keith Parker pointed out that on average the market has returned 16 percent in the year after one in which P/E ratios have dropped significantly. In fact, going back to World War II, there have been only two years in which the market has dropped after a more than 1 percentage point drop in valuations the year before. Parker predicts that the S&P 500 will rise to 3,200, or more than 20 percent, by the end of 2019.
On top of the valuation drop, he points to a high consumer savings rate, a rebound in companies investing in the U.S. and rising productivity as reasons the market will climb next year. But there are also reasons to believe the traditional rebound won’t materialize this time. First of all, while down, the absolute level of stock market valuations are not that low. For instance, the P/E ratio dropped to 12.8 in late 2008 before the market rebounded the next year. The P/E ended at a lower point than it is now in six of the 10 years in which there were big valuation drops.
This is another example of an extremely bearish article which, despite highlighting the tendency of markets to rise after big declines, goes on to conclude “So, no, you’re not wrong that the market is looking shaky. The bad news is that it could still get worse.”
Here is a more balanced view from another article “We view the sell-off as overdone and a bull-market correction, with valuations that have become more compelling,” Jason Draho, head of asset allocation, Americas, at UBS Global Wealth Management wrote in a note. “We recently increased our overweight to global equities on the view that the markets are already pricing in growth and trade risks.”
There is certainly a market right now in views on the direction of stocks. That is a signal there is a war going on between supply and demand and the range tells us the competing arguments are in relative equilibrium.
On one hand we have the ranks of people who have been buying the dip over the last decade and have always made money from following that strategy. That strategy is now being tested.
On the other you have the ranks of people worried about interest rates, the trade war and the looming end of the fiscal impetus from the Trump tax cuts who are pricing in a recession.
They can’t both be right. The S&P500 has held a progression of higher reaction lows since February and that would need to be broken to give credence to a deeper correction hypothesis. Seasonally, we are also entering one of the most favourable times of the year, the holiday season, so I question whether this is the right time to be getting more bearish.