Why the S&P 500 Dip Doesn’t Mean the Bull Market Is Over Just Yet

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S&P 500 - Why the S&P 500 Dip Doesn’t Mean the Bull Market Is Over Just Yet

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The 10-Year Treasury yield is breaking out to nine-year highs, and the market is freaking out. As the 10-Year Treasury Yield has pushed past 3%, 3.1% and 3.2%, the S&P 500 has dropped in a big way. Two days ago, the widely followed index was making its way towards 3,000. Now, it’s below 2,900.

Is this the end of the bull market? Is it time to throw in the towel and cash in on a decade worth of profits?

I don’t think so. Inflation is the S&P 500’s boogeyman. But there are still many warning signs out there. The yield curve is awfully close to inverting. The unemployment rate is at historically low levels. And since 1970, they’ve only been this low prior to bear markets. Valuations are above normal. Meanwhile, bull/bear ratios among investors are pretty high right now, and have been for some time, meaning that there is a lot (maybe too much?) optimism out there.

In other words, this bull market does look susceptible to a break. But, that won’t happen now, or anytime soon.

Markets have historically performed quite well when yield curves are flat, and don’t tend to peak until more than a year after yield curve inversions. The unemployment rate is low, but America’s broad economic prowess supports the full labor situation. Valuations are only above normal if you don’t consider the implication of tax cuts. And, bull/bear ratios were this high for this long from 2013-14. The market took a breather in 2015, but then resumed its long-term uptrend in 2016.

Overall, there is really only one thing that concerns me about the market today: inflation.

Inflation is this market’s deciding factor. If inflation remains checked, markets go higher. If not, markets go lower. I have confidence it will remain checked, and as such, I have confidence in the S&P 500 rebounding from this sell-off.

Markets Will Head Higher So Long As Inflation Remains Checked

Right now, we are dealing with a 10-Year Treasury Yield around 3.2% and climbing and an inflation rate in between 2% and 3%. So long as these current economic conditions persist in the near term, the stock market can support higher prices. Since 1950, when the 10-Year Treasury yield has been between 3-4% and the inflation rate has been between 2-3%, the average trailing earnings multiple for the S&P 500 has been roughly 18.6.

Earnings for the S&P 500 this year are expected to be around $162. That combination of a historically average 18.6 multiple on $162 in earnings implies a 2018 end price target for the S&P 500 of essentially 3,000. Moreover, assuming that the 10-Year Treasury Yield stays between 3-4% and inflation remains checked around 2-3% in 2019, an average 18.6 multiple on 2019 earnings of $179 per share implies a 2019 price target of 3,330, or 15% upside over the next twelve-plus months.

Thus, so long as inflation remains checked, this market will head higher.

Where things get tricky is if inflation starts to run wild. Let’s say the 10-Year continues to rise and stabilizes above 3.5%. But, as opposed to the 10-Year rising due to economic growth, it rises due to inflation and rate hikes. In such a scenario, we would be looking at a 10-Year between 3-4%, and an inflation rate between 3-4%, too. Historically, under such economic conditions, the S&P 500 trades at just 15.6 trailing earnings.

Moreover, if inflation does get out of control and undermines economic confidence and activity, earnings estimates will likely come down. Next year’s $179 estimate could fall to $170 or lower. A 15.6 multiple on $170 implies a 2010 price target of just 2,650, nearly 10% downside from current levels.

In other words, this market will head higher so long as inflation remains checked. But, if inflation runs wild, this market could fall.

Why Inflation Should Remain Under Control

There are many reasons why inflation will head higher. The labor is market is full, and finally starting to show signs of consistent and healthy wage growth. Commodity prices are rising due to numerous reasons, and this is especially true on the important oil front. The economy is heating up, and with a heated up economy comes higher inflation. Tax cuts have supercharged growth, and such a stimulus usually corresponds to higher inflation, too.

Thus, inflationary forces are here to stay.

But, the consensus expectation is for inflation to continue to run at a 2% to 2.5% rate, and not get much higher than that in the long run. Why? The Fed.

The Fed has sounded exceptionally hawkish recently, and that’s because of rising inflation. Fed Chair Jerome Powell seems determined to keep inflation in check with consistent rate hikes, and as such, most economists do not expect inflation to head that much higher.

The Fed being so aggressive does create another risk for the market, however, and that is over-tightening, which could kill economic activity domestically and globally. But, such risks seem overstated and premature at the present moment.

As such, the Fed should be able to contain inflation while preserving current economic growth. That combination should keep the 10-Year Treasury yield between 3% and 4%, and the inflation rate between 2% and 3%. Under those conditions, the S&P 500 will head towards 3,000 by year-end, and trend towards 3,300 in 2019.

Bottom Line on the S&P 500

The bull market isn’t over. It’s just taking a breather because rates are rising, and valuations and expectations need to re-adjust. This readjustment isn’t a big one, nor a lethal one for the market. Thus, big dips should be viewed as buying opportunities.

During this sell-off, the S&P 500 has already tested and bounced off of its 50-day moving average. Thus, if the rebound continues, this is a rally worth buying. If it fades, you’ll want to wait for the index to test its 200-day. That support level has been solid for a long time, and should remain solid again this time.

As of this writing, Luke Lango did not a hold a position in any of the aforementioned securities. 


Article printed from InvestorPlace Media, https://investorplace.com/2018/10/why-the-sp-500-dip-doesnt-mean-the-bull-market-is-over-just-yet/.

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