The sudden rise in financial-related concerns sent Wall Street into bear territory Tuesday, raising questions about the strength of the inventory market.
The stock selloff was triggered by the Federal Reserve's decision to raise interest rates, which has raised concerns about the financial system's health. On Wednesday, investors are hoping for a big gain as the market begins to recover from its recent losses.
Despite the mixed performance of the stock market on Tuesday, the Dow Jones Industrial Average and the S&P 500 were still in the red. The S&P 500 and the Nasdaq are in a bear market after dropping more than 20% from their highs.
Despite the market's recent decline, many traders believe that the worst is probably over. The numerous declines in various market sectors over the past 12 months have not been surprising, given the state of the US financial system and the overall economy. However, the negative sentiment can often lead to a prolonged recovery.
Excessive valuations
Despite the market's optimism over the past few months, many investors still believe that the recovery will be slower than expected. Excessive valuations will continue to remain a major factor that will determine the market's performance.
Despite the decline in the S&P 500 over the past 12 months, many analysts and traders still believe that the market's excessive valuation is a major factor determining the market's slumping performance. The S&P 500 was trading at 15.8 times its projected earnings for the next 12 months, which is still above the long-term common of 15.7.
When the market is in a slump, traders will often determine that the price of stocks is much less than it was at its peak. In December 2018, during the most up-to-date period of the Federal Reserve's rate-raising cycle, the S&P 500 was trading at around 13.8 times its projected earnings. During the March 2020 selloff triggered by the Covid-19 pandemic, the index was trading at around 13.4 times its earnings.
Unfinished dip
According to Greg Swenson, a portfolio supervisor at Leuthold Group, the market doesn't typically bottom near historical medians. But it tends to overshoot on the downside.
Another factor contributing to the market's decline is the increasing concerns about the quality of company earnings. Many traders believe that the multiple measures used to evaluate the market's performance may be understating the actual value of stocks. US firms have also warned about various factors, such as the rising prices of oil and the impact of a stronger dollar.
Another valuation model commonly used to evaluate the market's performance is the Buffett Indicator, which compares the worth of US-based companies with the country's GDP. As of the end of last week, the indicator was showing signs of being overvalued, with a model showing that it was around 29% above its historical common and peaked during the dot-com bubble of 2000.
Repeating history
The Federal Reserve expressed concern about the over-valued positions in some US equity markets in 2014. These include the small-cap and biotechnology sectors.
The Fed's unusual comments on the over-valued positions in specific market sectors sent stocks lower. The comments included in the Fed's monetary policy report were the first time in 14 years that it had explicitly discussed the valuation of a specific equity sector.
In a testimony before the Senate Banking Committee, Fed Chair Janet Yellen noted that the valuations of various equity markets remain in line with long-term averages.
However, the central bank noted that the multiples for small and microcap companies and those in the social media and biotechnology sectors are high relative to historical norms.