Should investors be worried about a pullback in equities? - J.P. Morgan Asset Management

Should investors be worried about a pullback in equities?

Contributor David Lebovitz

The S&P 500 is up over 10% this year, but the largest pullback we have seen has been a mere 3%. As a result, many investors are on the lookout for a correction in the equity market despite a healthy fundamental backdrop characterized by moderate economic growth, robust earnings growth, and interest rates which should only rise at a gradual pace.

This concern has recently been amplified by a series of hurricanes striking the southern coast of the United States, as well as rising geopolitical risks and elevated valuations. While some concern about geopolitical risks and elevated valuations may be warranted, it is important to remember that double-digit corrections are normal, and should be expected. In fact, the market has seen an average peak-to-trough decline of more than 14% each year over the past 37 years. However, in 28 of those 37 years, the market has gone on to finish the year in positive territory. In other words, if the S&P 500 was a baseball player, it would be the best hitter in Major League history.

Furthermore, if we do see a 10% correction, what would prevent it from becoming more severe? Based on the forward P/E ratio of the S&P 500, U.S. equities are about 9% expensive relative to their long-term average. Thus, if markets were to sell-off by 10% and earnings remained unchanged, valuations would drop back below their long-term average, presenting a clear opportunity for investors, particularly relative to high quality fixed income. It is important for investors to remember that earnings are the fundamental driver of stock prices. In other words, when you buy a share of stock, what you are paying for is a share of future profits – as long as those profits are there, the fundamental case for owning equities remains intact.

A 10% correction would leave U.S. equities cheaper than average

S&P 500 forward P/E ratio

Sources: Standard & Poor’s, IBES, FactSet, J.P. Morgan Asset Management.

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