Despite Friday’s bullish efforts, there’s no getting around the fact this past trading week was a real wake-up call … a reminder that the market isn’t infallible, and doesn’t simply shrug off every headwind it faces.
In numerical terms, the Dow Jones Industrial Average is on pace to end the week down a little more than 3%, which translates into a pullback of roughly 8% from its early November peak.
And yet, as painful as the week has felt, the pullback itself hasn’t actually been all that big by historical standards, and is certainly not — contrary to what some headlines suggest — an ironclad clue that a new bear market has assuredly begun.
The whole thing raises the question though … at what point should investors start to panic? For that matter, how far might the Dow Jones Industrial Average need to fall before stocks become too much of a bargain to pass up?
A Technical Look at the Dow Jones Average
There are several ways to analyze the Dow from a technical perspective, though all of them ultimately work together one way or another. There are two ways of particular interest right now, however, to anyone searching for a plausible bottom.
First (though not necessarily foremost), the 16,033 level is a major line in the sand for the Dow Jones Industrial Average. Though the index actually moved below that mark briefly in August, the 16,033 was the more active floor during the reversal effort, and the 16,033 level has been a key floor a few times even as far back as early 2014.
You’ll also see the 26-week Bollinger band currently rests nearby at 16,046. Given its history as a technical floor in addition to the fact that it’s teaming up with a straight-line support level, we can count on the bulls putting up a fight there.
Click to Enlarge The other set of lines plotted on the chart at right are Fibonacci retracement lines; the only one of interest right now is the one plotted at 15,397.
This set of Fibonacci lines uses one of the index’s biggest “resets” of this bull market as the starting point … the late-2011 stumble. It’s no coincidence the 38.2% retracement line at 15,397 was the starting point for the August rebound effort.
A Fundamental Look at the S&P 500
While the Dow is our focal point here as a proxy for the broad market, the blue chip index isn’t necessarily the best one to use as a fundamentals barometer. The Dow Jones stocks are hand-picked as the best of the best, and as such don’t reflect the fiscal strength of the stock market as a whole. The S&P 500 is a fairer view of the market’s fundamentals, as it encompasses the bulk of the stock market’s total market cap.
With that as the backdrop, the S&P 500’s current trailing price-to-earnings ratio is still a frothy 18.22 (assuming the index earned the expected $29.23 for Q4 of last year), and its forward-looking P/E is 15.36 (based on 2016’s current earnings estimates). The trailing P/E is uncharacteristically high, although the projected one isn’t.
The average forward-looking P/E for the S&P 500 varies between 14 and 16, depending on the timeframe in question, while the long-term average trailing P/E is only 16.
Click to Enlarge It should also be noted, however, that the S&P 500 rarely lives up to its longer-term earnings expectations; the earnings estimates are usually reeled in as the reporting date moves closer.
In other words, that attractive forward-looking P/E isn’t likely to be an accurate assessment of the S&P 500’s future value. Even with just a quick glance at the earnings chart, we can see 2016’s per-share earnings outlook are above trend.
Regardless of the nuances, from a historical perspective the S&P 500 is overvalued by anywhere from 13% to 21% at its current value. Assuming the Dow Jones Industrial Average is similarly overvalued, one could argue a slide all the way back to 13,679 could be justified. At the less-terrifying end of that scale is a more palatable pullback to only 14,336.
A move to 14,366 would translate into a 22% pullback from the Dow’s peak in May.
That’s bear market territory.
The math raises a question … several questions, actually. Three of the biggies:
- Do we trust the forward-looking earnings estimates, which are a bit on the optimistic side?
- Do stocks actually need to revert back to their long-term norms at this time? (Maybe they don’t, negating the fundamental aspect of the discussion.)
- Where are oil prices going, and how/when are investors going to price that into energy stock valuations (which they haven’t yet)?
Bottom Line for the Dow
To answer the key question, investors shouldn’t panic until the technical floor at 15,397, although a break under the minor floor at 16,033 serves as a red flag. Warning: A move to that support level will feel terrifying at the time.
If the support at 15,397 should fail to hold the Dow Jones stocks, at that point investors will likely be convinced a bear market is inevitable and end up making it happen. That’s when the Fibonacci retracement line at 13,619 comes into focus, which lo and behold is right around the “proper valuation” level of 13,679 (which is not a coincidence). At that level, the Dow will have fallen 26% from its high.
Let’s hope it doesn’t come to that, but let’s mentally prepare for it if it does.
In the meantime, again, don’t panic until the index breaks under 15,397. A correction to that mark wouldn’t be entirely out of the ordinary.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.
