As the stock market begins to recover from the recent correction, investors may view this as an opportunity to invest on the cheap. Stocks may be cheaper now than they were last month, but that does not mean that they are actually cheap.
Amidst the continued wave of investor euphoria, intelligent investors need to step back, understand why the market has performed so well over the last 10 years and how it led to the correction, and what it means for stocks going forward. While a bear market is not necessarily on the horizon, now is not a good time to carelessly buy out of a misguided belief that stocks are cheap.
The Fundamental Causes
Let us rewind the clock back about a week when the correction began. As The Washington Post correctly noted, investors got nervous when the U.S. Labor Department reported on February 2nd that jobs were added and wages were rising. While this is good news for the economy, investors are worried that shrinking corporate profits, combined with the Federal Reserve’s clear desire to raise interest rates, will lower stock values. Investors thus sold off in advance, which ended up triggering the correction.
The key here is that those fears are no less valid today than they were nearly two weeks ago. The Federal Reserve will still likely raise interest rates even after this drop off, as CNBC reported that New York Fed President William Dudley called the fall “small potatoes” and stated that the Fed will likely raise interest rates in March, limiting how much more stocks can climb. Furthermore, stocks rose over the past year partly out of hope towards President Trump’s economic plan. But with the tax reform bill signed into last year, and the new budget last week, Trump’s ability to positively affect the economy further will be highly limited.
In addition to all the reasons why we might expect the market to take a hit, the fact is that stocks are not cheap even after the correction. As Reuters reported last Tuesday, the S&P 500 last week still had a price to earnings multiple of 16.9, which fell further to 16.3 by Friday. This is still higher than average, and in and of itself would suggest that at the least, stocks are not cheap.
Some investors would argue that valuations are not useful for trying to dodge a bear market or predicting how the market will look in the short term, and they are not wrong. But that should not take away from the fact that stock market is highly valued, and to argue that they are cheap is to argue that the valuation will increase even more. And the simple fact is that there are more reasons to suggest it will decrease instead of blithely assume that the great market from last year will return. The conditions are different today.
Where to Look
The incredible bull market of the past few years may not continue, but that does not necessarily mean doom and gloom. Nevertheless, investors should take this time to reprioritize their investments and look for opportunities.
More aggressive investors who want to find a relatively cheap stock should aim at companies or sectors which were hardest hit by the correction. Fortune lists Wells Fargo (NYSE:WFC), Chevron (NYSE:CVX), and Exxon Mobil (NYSE:XOM) as three companies which were particularly hard hit, and theEnergy) and Healthcare industries suffered, affecting car insurance comparison businesses and others. Industries like these are the closest there is to a cheap stock in the current market, and thus should be strongly considered.
In addition, now is a very good time to reassess your portfolio and consider diversifying into other assets such as bonds or near cash securities. These investments will explicitly benefit from the Federal Reserve rate hike we all know is coming, and should be strongly considered as safe investments during the current volatile period on the market.
Time to be Cautious
There is always a lot of volatility when a bear market approaches, and there has been plenty of volatility for the stock market recently. Investors should remember that the stock market’s fortunes are not necessarily tied to the U.S. economy’s fortunes, and the recent correction is proof of that. Stocks are not cheap even after the correction, and investors should not blithely assume that the recent recovery signals all clear. There are more reasons to assume that the market will slow down or tumble than continue to grow as the years of easy money comes to an end. Stay cautious, diversify into bonds, and pick select opportunities here and there.