In the past 20 years, our economy has seen 3 market drops of 30% or more. Understanding the market conditions (and mistakes) that caused them gives us insight into our current economic environment. It helps us shape a better picture of what to expect and what to prepare for. This is our current assessment of the market volatility and the mild anticipated pullback we anticipate is just around the corner.
Understanding Price-to-Earnings Ratio in Stock Values
The stock market is trading at a very high PE (price-to-earnings ratio). This means you're paying a lot of money today compared to every dollar of earnings coming out of, let's say, S&P 500 companies.
Picture the ratio visually - price over earnings. As the bottom number (earnings) increases, the lower the price-to-earnings ratio is, mathematically speaking. One of two things has to happen for that PE ratio to come back down into a historically normal range.
- Stock prices can come down
2. Company earnings can come up
We would love to see some combination of ongoing increased earnings to raise the PE ratio and increase the value of our investment options.
A Look Back at Recent 30%+ Market Pull Backs
Please think about the last three times that the stock market has pulled back by, let's say, 35% or more.
- The first quarter of 2020 when the pandemic hit
- In 2008 during the housing crisis
- In 2000 - 2002, when we were coming off of the internet bubble and then got hit with 9/11 and the start of the War on Terror
So, the last three times, we had some systemic hit that caused a 35-60% plus drop in stock prices; there was something fundamentally, systemically wrong with the market.
The Y2K Crash
In the late nineties, you had the overblown valuations associated with the tech market and the run-up to Y2K. If you think about it, we spent ten years' worth of technology budget in that last two years because everybody was afraid their computers were going to stop working.
Suddenly in 2000, nobody had any tech budget, and all the tech companies crashed because nobody was buying their products. And that was because we spent all the money in '99.
The 2008 Housing Crash
Come 2007 to 2008, the market peaks out. It starts to drop in October 2007 and falls to 40% in 2008 through March of 2009. It was an 18-month run there, 60%+ top to bottom, andthat was all predicated on the debt bomb. It came from the mortgage debt crisis with that was overleveraged and overbuying and no-documentation loans and interest-only loans and all of the other kinds of mortgages. I don't know if you've gotten a mortgage lately, but they're not doing no-doc loans anymore.
The 2020 Covid Pandemic
Now we're to the present day. We're getting through this pandemic. Even if we get a couple of more variants or things like that, we're probably not going to repeat the same kind of fear, shock, and awe in the markets the next time. At this point, we don't see a reason for another dramatic 30, 40, 50% pullback.
Preparing to Capitalize on a Possible Mild Pullback
But as I've said before, we do have some dry powder. We are positioned conservatively in anticipation of maybe a 10 to 20% pullback. That would be in coordination with what we think will be gradually rising earnings. Think of it as the markets way of trying to get the PE ratio back into kind of a normalized range. Because as of right now, it's above the high end of the normalized spectrum.
We hop you found this helpful. Please feel free to share with anyone who is nervous about the current economic picture and how it impacts your financial future. Here at Vizionary Wealth Management, we're always here with perspective for the decisions ahead.