After recently hitting a string of record highs, stock markets around the world are in retreat — with the Dow Jones industrial average shedding 400 points Tuesday after a global sell-off that started in China.
That leaves investors with a tough choice. Is this a brief stumble in an otherwise strong, global stock market? Or is the recent pullback the beginning of a nastier slide?
The immediate cause of China’s stock meltdown appeared to be talk of a capital gains tax there to slow a wave of speculation that has sparked a market surge reminiscent of the U.S. bubble in the late 1990s. Stock prices on the Shanghai exchange have roughly doubled in six months, including a 15 percent run in the two weeks leading up to Tuesday's big sell-off. In that context, Tuesday's 9 percent pullback in Shanghai seems relatively tame.
But with U.S. markets posting stomach-churning drops, some observers say U.S. stocks also have been due for a breather. The broad Standard & Poor’s 500 index was up nearly 20 percent since mid-2006 before beginning to fade last week.
“The S&P 500 has had eight consecutive monthly increases without any significant corrections,” said Alexander Paris at Barrington Research in a note to clients on Monday. “And there are a lot of nervous paper profits to be taken if sentiment is indeed changing.”
The casual observer can be forgiven for missing that change in sentiment. In fact, there are still plenty of professional investors who insist that nothing has changed to make stocks worth substantially less than they were Monday.
Companies have been reporting fairly solid profits, interest rates and inflation are still relatively tame, oil prices have backed off their highs, and the U.S. economy posted a healthy 3.5 percent gain in the fourth quarter despite a major pullback in the housing and auto markets last year.
Some analysts say you should look at the recent pullback like a markdown at the mall: It’s time to go shopping. Bulls like Anthony Dwyer, a strategist at FTN Midwest Securities, figure that though there may be “a couple of nasty weeks ahead” there is not enough bad news to signal a longer-term market retreat.
“The macroeconomic environment doesn't change overnight,” he said. “So we're dropping from a near 52-week high, (but) things are still pretty good.”
The question overhanging the market pullback is whether those good times will continue to roll. Former Fed Chairman Alan Greenspan cast some doubt on the economic outlook Monday when he told a business conference that after uninterrupted growth since 2001, he now sees signs of a looming recession.
“When you get this far away from a recession invariably forces build up for the next recession, and indeed we are beginning to see that sign," Greenspan said.
Trouble signs include recent reports of rising defaults in the so-called “subprime” mortgage market — which consists of people who are stretched for credit even in good times. That has thrown cold water on hopes that the housing market is on the mend. The worry is that if the increase in defaults prompts lenders to tighten up on easy credit, the housing market — and the U.S. economy — could be in for a bumpy year.
“It is tempting to say that the worst (of the housing slump) is now behind us, but that would be premature,” said Patrick Newport, an economist at Global Insight in a note Tuesday.
Investor sentiment could get another jolt Wednesday, when the government releases a revised report on GDP growth for the fourth quarter of last year. Some economists note that data available since the initial report came out last month point to a sharp cut in the revised number.
A lot depends on whether the recent strong run in corporate profits continues. One common measure of whether stocks are trading at a reasonable price is the ratio between the earnings per share and the stock price.
The so-called price-earnings ratio for the stocks in the S&P 500 has averaged about 15.6 for the last 70 years. During the U.S. market bubble, that ratio doubled. Then, as recession took a big bite out of corporate profits, the ratio continued to climb. As recently as the end 2001, the S&P 500 price earnings ratio was 46.
Since then, as profits have improved, that ratio has backed down to the historical average, meaning the stock price you’ll pay for a dollar of corporate profits is just about in the middle of the historical range.
Regardless of where the overall market is headed, the falling market indices don’t tell the whole story. As always, not every stock marches in the same direction as the overall index. So individual stocks may behave very differently than the market indices suggest.
Michael Chren, who manages the Allegiant Large Cap Value Fund, notes that the five biggest stocks in the S&P 500 index — GE, Microsoft, Exxon, Citigroup and Bank of America — are trading at about 13 times earnings.
“On other end of the index, the smaller mid-cap names are trading at extreme valuation,” he said. “So this is opportunity for people to move away from risky stocks into less risky stocks.”