By Jon Sindreu
For investors who have complained about the stock market being too expensive, last week's sudden rout has something good to offer.
Major U.S. indexes ended the week Friday more than 5% lower, marking their worst loss in more than two years, despite a growing global economy and optimism about corporate profitability. Analysts blame the stock selloff on a series of misfired bets on low volatility and on higher bond yields, which makes stocks less attractive compared with low-risk government paper.
This was troublesome, analysts and investors said, because the stock market's price-to-earnings ratio -- how many times stocks trade above the earnings they are expected to generate over the next year -- were high by historical standards. This means that, even as analysts expected corporations to continue delivering strong earnings, their shares looked expensive.
"We have written many times about our concerns on valuations on both bond and equity markets," said Paul Flood, multiasset portfolio manager at Newton Investment Management. "Many investors had started to view markets priced to perfection as the only likely path forward."
Last week's sharp correction, which didn't alter analysts' optimistic view about the economy and corporate earnings, could alleviate some of those concerns.
Companies in the S&P 500 are trading at 16.5 times their earnings, according to Morgan Stanley data, which blend firms' past profits with forecasts for the next year. That compares to the index trading at 18.1 times those earnings two weeks ago, and it is much closer to the S&P 500's 10-year average of about 15.
Price-to-earnings ratios for stock markets in Europe, Japan and emerging-market economies have fallen by almost as much as in the U.S., even though they all traded at cheaper levels to start with.
Even with the lower valuations, the prospect of rising U.S. bond yields remains a concern for stock purchasers, particularly those who believe inflation is set to go up by more than previously expected. Higher inflation could prompt central banks to tighten policy at a faster rate.
But stocks have also gained some small amount of ground on government debt. Another valuation measure for the S&P 500, which calculates the extra compensation investors receive for buying stocks rather than inflation-linked bonds, has now climbed above its long-term average going back to 2000.
The U.S. selloff was also across most corporate sectors, further evidence that the declines were triggered by short-volatility as investors scrambled to cover their losses, some analysts say. That meant investors were less discriminate and that companies that could benefit from the recent rise in bond yields, like banks, were sold with the rest.
Investors who are waiting to "buy the dip" can often allow corrections to run their course, instead of stepping in immediately, in order to scoop up even bigger bargains. But after closing higher on Friday, global stock markets had another positive day on Monday, suggesting that some money managers are already ready to buy these cheaper stocks.
"Time to pick stocks," equity strategists at Morgan Stanley told clients in a research note Monday. "We have advocated patience in buying this dip," they said, adding that current measures of stock valuation were now attractive enough for "disciplined buyers."
Many investors point out that stock markets have usually recovered quite well from sudden selloffs that happened after a period of market optimism. A classic example is Black Monday in 1987, when the Dow Jones Industrial Average had its worst single day on record -- it plunged 22.6% -- but afterward enjoyed years of rallies.
"If history is any guide, most bull markets end because we are going into recession, not because of an overvalued market," said Chris Zaccarelli, chief investment officer at Independent Advisor Alliance LLC.
Write to Jon Sindreu at firstname.lastname@example.org