Spooked investors brace for ‘correction’

Experts look for signs of potential bubble after last week’s market plunge

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As the Dow Jones industrial average and S&P 500 climbed to all-time highs this summer, many investors have been bracing for a pullback.

That happened in dramatic fashion last week with stocks posting their biggest one-week loss in two years, leading investors to wonder if they should start liquidating shares before prices fall even lower or take advantage of what could be a buying opportunity.

“Most investors were surprised to see the type of market rally we've had since the beginning of 2013,” said George Emanuele, an investment adviser with PNC Wealth Management, Downtown. “With the continued market rally in 2014, many experts feel we are long overdue for a correction, as we are more than 700 days without a sell-off of at least 10 percent.

“Historically markets correct by 10 percent every 161 days, but given the continued economic recovery, low interest rates and low inflation, this market rally has been able to avoid a normal correction despite the geopolitical concerns that are rising.”

The Dow Jones industrial average erased all of its gains this year when it fell more than 300 points Thursday. The S&P 500 also saw its biggest weekly decline since January 2012 when it dropped nearly 3 percent from its high. By Monday, the selling frenzy had leveled off and markets, for the most part, were flat.

The Dow gained 0.46 percent Monday. The S&P 500 gained 0.72 percent; and the Nasdaq was up by 0.72 percent.

Investors began racing for the exits last week when a slew of economy news came out that led them to believe the Federal Reserve would act sooner rather than later to raise interest rates and possibly raise them aggressively.

Second-quarter GDP numbers released by the federal government Thursday were up 4 percent as opposed to negative 2.1 percent for the first quarter. Also Thursday’s employment cost index was up above expectations, which suggests potential wage inflation creeping into the economy.

An employment report Friday showed the economy created 209,000 jobs in July, which was the sixth consecutive month of more than 200,000 jobs being created — the longest streak of positive jobs data since 1997.

“We have seen a shift in Fed policy that was unanticipated,” said Mark Luschini, chief investment strategist for Janney Montgomery Scott, Downtown. “The result is equity investors have had to re-rate equities to reflect the prospect that the lift-off date for raising the Fed funds rate may come sooner than expected.”

The Fed funds rate, the rate that major banks loan money to each other overnight, is currently zero percent to 0.25 percent.

Even though the benchmark interest rate is low by historical standards, any increase in the interest rate would increase the cost of capital for corporations with publicly traded shares.

Mr. Luschini said investors were spooked because if interest rates are set to rise, the methods investors use to evaluate stock prices based on future cash flow would have to reflect a higher cost of capital and profit.

While the rest of the economy has been growing at a snail’s pace for the past five years, stocks have been on a gravity-defying rise.

Although stocks could be in or approaching bubble territory, Larry Elkin, president of Palisades Hudson Financial Group in Scarsdale, N.Y., does not believes that’s likely.

“Bubbles generally occur when crowds convince themselves that the constraints or concerns of the past no longer apply. ‘This time is different’ is an atmosphere in which bubbles inflate,” Mr. Elkin said. “Investors convince themselves that assets that have soared in value — be they tulips, or gold, or oil or stocks — can only keep going up.

“That atmosphere, however, is not what we are” experiencing right now.

“While more expensive today than they have been in recent years, stocks are still not terribly pricey compared to companies’ earnings, which is what really matters,” he said. “Many of the companies in the S&P 500 that have posted earnings have beaten analysts’ estimates and exceeded sales projections, which gives optimism about stocks a reasonably solid foundation.”

Compared to today’s extremely low interest rates, stock prices are not very expensive, he said. In fact, the low interest rates themselves are spurring something of a bubble in the value of bonds, whose value increases as rates fall.

“The inevitable rise in interest rates will most likely be bad news for stock prices — eventually,” Mr. Elkin said. “But even a moderate rise in rates will leave bond yields at historically low levels that, in the past, have not been a big hindrance to stocks.”

Tim Grant: tgrant@post-gazette.com or 412-263-1591.

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