It seems markets are reaching new highs each day. This is a good thing… mostly, but the equity markets are extrapolating current COVID vaccine trends and estimates creating an expectation that normal life is on the way. This is a very reasonable point of view with recent economic data supporting such an assessment. Yet, the stock market has a tendency to get ahead of itself from time to time. This may be one of those times.
The stock market is often equated to the economic environment, which sounds reasonable. The economy is really a measure of business and commerce transactions. More transactions create higher revenue, which should translate into higher profits. Since stock prices are ultimately based on profits, stock prices should rise. This is very logical reasoning, although this relationship exists as a general association. Investor exuberance can push stock prices beyond a direct correlation.
The stock market can be thought of as an athlete. Stock market movements usually come in sprints followed by periods of rest. Those rest periods offer time for earnings to catch up to investor expectations. Rest can come in the form of a walk (a market inching forward), standing (a flat market) or sitting (a market pullback or correction). Only hindsight can determine which direction will be taken.
Rest periods via the pullback path is a normal healthy market action. This gives the market time to reassess expectations. This is akin to an athlete sitting on the bench, drinking some water and evaluating his performance.
Media often sensationalizes even minor pullbacks. A 1000-point pullback in the Dow Jones Industrial Average equates to only 3% at today’s index levels. This is very different from 10, 20 or 30 years ago when 1000-point pullback would have had a tremendously negative impact on investment values.
Monitoring market valuations, such as P/E or Price/Book ratios, relative to historical norms can offer insight into when a rest period may be on the way. Currently, aggregate valuation measures can be considered rich in some sectors. A rest period may be in the cards in the coming weeks or months.
Any rest period should not be evaluated in a silo, often the folly of media outlets. Weighing the economic backdrop, stock valuations and interest rate setting are fundamental to gauging rest period premonition. Currently, the economic backdrop is strengthening, suggesting a pullback would be a healthy “technical” rest and re-assessment of valuation measures.