The Dow’s 354-point plunge last week was the worst drop since the presidential election.
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The markets overreacted on the Federal Reserve’s signal it may withdraw from its stimulus. Traders are now seeing any downdrafts as a buying opportunity for lots of stocks, which still remain on certain valuation measures at their cheapest levels since 1954.
Ending artificial stimulus is a good thing. Investors can better figure out which companies have solid earnings growth, so it’s back to fundamentals. It will stop the artificial bubbles in commodities and emerging markets.
The Fed pullout is a sign the economy is getting stronger, which is nothing to fear - and all of that is good for stocks. The Fed pullout is also causing a natural correction in overbought currencies and lower-quality corporate bonds. The point of the U.S. central bank’s intervention was to reflate assets, and the economy, including housing. But not all boats deserved to be floated higher. (Does the Fed now have a triple mandate, not a dual mandate of just monitoring inflation and job growth?)
For a month and a half now, Wall Street has been in an uproar about the Federal Reserve’s plans to scale back printing money to buy $85 billion worth of bonds monthly, as many on the Street fear a terrific bull market for the past four years is coming to an end. The Fed’s money has leaked into the stock market , as returns on things like bank deposits are microscopically low. That’s why, even with the recent downdraft, the market is still up about double digits this year, still in shouting distance of the record it hit on May 28.
But here’s the back story to the “stop the market, the Fed wants to get off” routine: Even the most unreconstructed bull has to agree the markets may have gotten ahead of the economic recovery, the slowest since World War II. That’s why we have these emotionally wide trading swings. Even so, the Fed thinks the U.S. economy is recovering to grow at a 3% annual rate. With faster economic growth comes higher inflation in the form of higher prices, which increase corporate profits, which are good for stocks.
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But not so good for borrowers are higher borrowing rates, which are pegged to the 10-year bond, already at a 14-month high jumping to 2.4%, which is still historically low. A 3% U.S. GDP growth rate means the 10-year bond yield should go up to 5%. That’s still low, too, historically. When this bond moves higher, so do loans pegged to it. And besides, the central bank has already said it will raise rates if the economy improves.
Housing is in recovery, but it’s now questionable whether a rate hike would put it back on its heels, since loan rate increases may force borrowers to get up off their seats and into buying houses, which is likely why new and existing home sales numbers have been improving.
But again, the central bank’s coming slowdown was telegraphed already by various Fed governors who gave speeches indicating the central bank would make this move fairly soon, as unemployment came down to 7%, which the central bank thinks might happen next year. The jobless rate is down to 7.5% from 7.8% when the Fed ratcheted up its bond buying in September 2012.
Here’s what’s worth keeping in mind: Stocks are still cheap at 15.5 times earnings, which is lower than the 17.3 median since 1993, and lower than the average going back to 1954. Despite the Fed bond purchases, equity valuations generally haven’t moved higher.
Stocks are multiples cheaper than when they were in bubble territory in the late 1990s, and in 2004. Companies have cleaner books, less accounting shenanigans, they’re making real profits. They are sitting on around $1.8 trillion in cash, which could be deployed in a market downturn to buy stocks on the cheap.
Also, a footnote: The Fed can always restart its bond buying again as it’s done before if the economy slows down, joblessness moves higher and inflation remains weak.