3 Reasons the SPDR S&P 500 May Be Due for a Correction

While it's impossible to predict future movements of the market, there are nevertheless three reasons to suspect the SPDR S&P 500 could fall in the future.

Aug 14, 2014 at 10:00AM

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Let me be clear from the outset: I'm not predicting that the SPDR S&P 500 is on the verge of an imminent collapse. Despite the market's unprecedented heights, nobody actually knows where it will be today or tomorrow, much less a week, month, or year from now.

That being said, stocks go up and down. And there's little reason to believe this tendency will disappear anytime soon. As a result, I thought it would be worthwhile to discuss three reasons why the world's largest exchange-traded fund, the SPDR S&P 500, could drop sooner than many expect.

1. Stocks fluctuate

Few people in history understood money and markets better than J. P. Morgan, head of the eponymous banking house and the most powerful financier of the late 19th and early 20th centuries.

When Morgan's insight on the direction of the stock market was requested by investors, instead of delving into a long and complicated answer, Morgan would simply respond: "It will fluctuate."

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And the same holds true today. "You should, at minimum, expect stocks to fall at least 10% once a year, 20% once every few years, 30% or more once or twice a decade, and 50% or more once or twice during your lifetime," my colleague Morgan Housel has observed based on the market's historical performance. "Those who don't understand this will eventually learn it the hard way."

Indeed, since 1928 the S&P 500 has dropped by at least 10% from a recent high 89 times. And it has declined by 20% or more on 21 occasions. As Housel wrote, "Ten-percent pullbacks are almost as common as summers. Twenty-percent market drops have occurred...about as often as presidential elections."

2. Valuation

The fact that we can't predict where the market will go doesn't mean we can't have an opinion about where it is right now. And it's hard to deny that stocks today are expensive on a historical basis.

The most widely cited measure of this is Yale economist Robert Shiller's cyclically adjusted price-to-earnings ratio, which is a smoothed and inflation-adjusted estimate of the S&P 500's historical valuation since the late 1800s.

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As you can see, there have been only three periods over the last 100-plus years during which stocks were more dearly priced than they are right now: the Roaring Twenties, the technology bubble around the turn of the century, and the housing bubble that preceded the latest financial crisis.

Does this portend an impending collapse? No. But it certainly isn't auspicious either.

3. Interest rates

Interest rates and stock prices are inversely correlated. As Warren Buffett explained in a famous 1999 Fortune article, "[Interest rates] act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull." And the same is true in reverse.

The last three decades serve as a textbook example of this relationship. Thanks to the work of former Federal Reserve Chairman Paul Volker, who broke the back of double-digit inflation in the early 1980s, government bond yields (i.e., the arbiters of interest rates) began a decades-long descent that only recently approached the natural barrier of 0%. Over this same time period, meanwhile, stocks experienced the most extraordinary bull market in the history of modern finance. 

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Today's unprecedentedly low interest rates, in other words, have a lot to do with the current level of stock valuations and prices. Consequently, as the economy picks up steam and sends rates higher, one would be excused for expecting the S&P 500 to respond inversely.

The takeaway on the SPDR S&P 500

Let me reiterate my earlier caveat: I have no idea what stocks will do in the future. In fact, one could even argue that we have no idea why stocks did what they did in the past.

Ultimately, if we're honest with ourselves, the most we can say is that they will fluctuate. That was a good enough answer for J. P. Morgan, and it's good enough for me.

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