Is the market in a normal correction, or is this the start of something more serious?
After plunging more than 12 percent in August, the S&P 500 index has rebounded 8 percent.
So does that mean the storm has passed? Probably not. The problem is a shortage of cash that the big institutional investors can use to buy equities after the Federal Reserve ended its quantitative easing program in late 2014. The Fed had been purchasing $85 billion of bonds a month.
In addition, the S&P 500’s price-earnings ratio, using five years of earnings, is 20, up from a long-term average of 17. The weakening of transportation, utility and industrial shares is also a warning sign for the market.
This looks more like a cyclical bear market than a normal correction, meaning a decline of 20 to 25 percent. A 25 percent drop from the S&P 500’s May 20 record high of 2,130 would put the index at 1,600.
Nobel laureate economist Robert Shiller wrote in The New York Times that a return of his cyclically-adjusted P-E ratio, which take into account 10 years of earnings, to its historical norm, would put the S&P at 1300.
The volatility in the market is not over for two reasons. First, we don’t know what the Fed’s going to do. And second, the China currency devaluation was a game changer. Until those two things are resolved, I think it’s going to be hard for the market to find a bottom anytime soon.