This week was full of mixed market and economic news. In terms of the economic situation, the situation remains positive. Economic growth last quarter was nearly 5 percent, well above expectations, and personal spending rose for a sixth straight month. However, when it came to markets, it was a different story. Markets have pulled back again, and the S&P 500 looks set to enter a correction, down more than 10 percent from its recent high in August.
What’s happening here and what does it mean for the way forward?
Prices and valuations
At first glance, the market decline doesn’t seem to make much sense. However, an unfortunate side effect of economic growth is that interest rates are likely to remain higher for longer, and that is something that markets have begun to realize. Interest rates on 10-year U.S. Treasuries remained near 5 percent throughout this week and last as markets held higher prices for an extended period of time. Meanwhile, valuations for stocks that move against interest rates have fallen from about 20 times next year’s earnings to about 18 times. This is a big change that explains the market crash.
The road lies ahead
What does this mean for the future? The good news is that, at least for now, interest rates appear to have stabilized, which should limit further declines in valuations in the short term. Over the longer term, the valuation correction should be offset by earnings growth, which is still expected to be strong over the next few quarters.
With the economy still healthy and earnings expected to rise, the current sell-off looks more like a correction than something worse. Nobody likes a market crash. However, with solid economic fundamentals, we have some cushion here. The current decline of about 10 percent is quite normal. In fact, it’s something we usually see once a year. Even if things get a little worse, it will also be normal and something we have seen many times before.
Is it normal?
In other words, while it hasn’t been a great week for markets, it’s a normal pullback that makes sense given financial conditions. From what we see now, the long-term outlook for the market remains positive.
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