Is the Stock Market Finally Faltering?

It was a tough day for stocks, with the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) both falling 1.4%.  

That sentiment is showing up in the equity options market. Predictably, the VIX Index (VOLATILITYINDICES: ^VIX  ) , Wall Street's fear gauge, rose 7.5% to close at 17.50 -- its highest close since mid-April and the third-highest close this year. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

Is the rally over?
First, investors ought to take a breath. Even after today's decline, the S&P 500 is less than 4% below its all-time closing high of 1,669.16 of May 21. The U.S. market isn't turned Japanese yet (Japan's Nikkei 225 index has now lost 16.7% in the space of 10 trading days. A few more percentage points and Japanese equities will be in a bear market.)

Wall Street seers aren't concerned, apparently. In a research note (requires login) published today, Credit Suisse equity strategist Andrew Garthwaite is raising his year-end target for the S&P 500 to 1,730 (from 1,640), and is recommending investors "stay overweight equities" on the basis (among other reasons) that "the risk/reward balance in credit looks significantly worse than that for equities."

Echoing this notion (which is received wisdom on Wall Street) in today's Financial Times, Goldman Sachs' chief global equity strategist Peter Oppenheimer writes:

While equity prices have rebounded strongly since the crisis, valuations in aggregate look reasonable, particularly given low interest rates and the gap between implied risk premia in equities and other asset classes (which in many cases have fallen to record lows).

In other words, stocks look reasonably priced by comparison with assets (bonds, in particular) that are at an extreme of overvaluation. Is that enough? If we assume that investors are only ever choosing between stocks and bonds, I'll admit this argument lends weight to the notion that we can expect continued support for stocks, but I don't see that it tells us very much concerning whether or not stocks are cheap on an absolute basis -- which seems to me a valid concern, particularly for long-term investors.

No one knows whether a correction in the stock market is imminent (defined as a 10% pullback from the high), but I think investors should be prepared for it. A one-way market that ratchets up daily gains like clockwork -- such as we have witnessed -- isn't sustainable. Volatility, including the downside variety, is a feature of the stock market. We hadn't seen it in a while, but we should expect it to return, which will be no bad thing. It's one-way markets that make me nervous.

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