An oft quoted line from celebrated fund manager Sir John Templeton stated, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” Market watchers pondered the veracity of this maxim as markets soared throughout 2017. Now, rattled by some volatility, the question on many investors’ minds has been: Are we end-of-cycle euphoric?
The current bull market for U.S. equities is approaching its ninth year and if sustained until August, will be the longest running bull market in the history of the S&P 500. However, since the beginning of 2018, it appears each week has offered new potential for corrections, or even a wholesale transition to a bear market. Most recently, concerns about the effect of the U.S. Administration’s trade tariffs—and China’s response—sent markets tumbling.
So how can investors tell the difference between a bull correction and the arrival of the bear? In a recent report, Morgan Stanley Research analyzed S&P 500 trends since 1950 to identify recurring patterns in corrections and market shifts and provide investors with some historical signs that change is afoot.
Bull Correction vs. Baby Bear
Market drawdowns happen more often than most investors realize. The report notes that since 1950 there have been more than 100 instances of 5% or more S&P sell-offs, and 32 times in which the drawdown was more than 10%. Over the past century, the likelihood that the S&P is down 5% or 10% at any given point in a year has been 46% and 29%, respectively.
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Value investing starts with low PE stocks, but it shouldn’t be an investor’s only financial metric.
What do Warren Buffett, Ben Graham, Seth Klarman, and Peter Lynch all have in common? Besides being wildly successful investors, they’re all are adherents to value investing, a method where one attempts to buy securities that have a higher intrinsic value than their current price.
One of the most basic forms of value investing is to find stocks with low price-to-earnings (PE) ratios. The PE ratio is a simple ratio that divides the current price per share of a company by the earnings per share over the trailing-12-month period. The logic behind buying low PE stocks is simple: As an investor, you are ultimately entitled to a pro-rata portion of company earnings, so paying the lowest cost, or multiple, for those earnings is preferable than paying a higher multiple. Essentially, your dollar is buying a larger portion of company earnings than it would with a high-multiple stock.