Why a 15% Sell-Off Could Prolong the Bull Market

While many investors are getting rattled by the October stock market sell-off, this actually may be good news for the bull market, according to Jim Paulsen, chief investment strategist at The Leuthold Group. As of the close on Oct. 23, the S&P 500 Index (SPX) was down by 6.8% from its all-time high, and by 5.9% for the month-to-date. CNBC notes that October is, so far, the worst month in nearly three years for the S&P 500. Paulsen told CNBC: "My guess is that we're going to have a bigger correction than we've had yet. I think a good gut check to sentiment, like a 15% correction, might be just the ticket to extend this bull market."

"I think a good gut check to sentiment, like a 15 percent correction, might be just the ticket to extend this bull market." —Jim Paulsen, The Leuthold Group

Source: CNBC

Significance for Investors

Paulsen believes that a correction, normally defined as a market decline of 10% or more, is necessary to bring equity valuations back in line with fundamentals such as rising interest rates, peaking corporate earnings, and increasing evidence that economic growth is on the cusp of slowing down. The S&P 500 set an all-time record high of 2,940.91 in intraday trading on Sept. 21. A 10% correction from that record would send the index down to 2,647, a level last seen on May 4. A 15% correction would bring it down to 2,500, where it last was on Sept. 27, 2017.

As Paulsen elaborated for CNBC: "What we need is a lower valuation, I think, to sustain a different environment if this recovery is going to continue. I don't think we can handle that environment at 20-some-times trailing earnings, probably more like 15 to 16 times trailing earnings and we're a ways from that." CNBC indicates that the S&P 500 currently has a P/E of about 19 times trailing earnings, while the technology and consumer discretionary sectors currently trade above 20 times trailing earnings.

Morgan Stanley, meanwhile, also believes that equity valuations have to come down, particularly among technology and consumer discretionary stocks, as well as among growth stocks in general. They base their analysis on the fact that the equity risk premium, or the difference between the earnings yield on stocks and the yield on the 10-Year U.S. Treasury Note, remains too low by historical standards. The upshot of their analysis is a pessimistic outlook under which the S&P 500 has limited potential for gains in the near future. In contrast to Morgan Stanley's pessimism and Jim Paulsen's cautious optimism, respondents to the latest iteration of Barron's Big Money Poll are clearly bullish, as summarized below.

Big Investors Are Bullish

  • The bull market will last through 2019, passing the 10-year mark in March 2019.
  • The S&P 500 will be at 3,078 by mid-2019, up by 12.3% from Oct. 23.
  • The S&P 500 will be at 3,166 by the end of 2019, up by 15.5% from Oct. 23.
  • A total of 56% of respondents are bullish on U.S. stocks through June 2019.

Source: Barron's

The Big Money Poll is conducted by Barron's twice a year, with the latest survey taken from Sept. 21 to Oct. 8, getting responses from 162 professional investment managers from across the country. While the poll was taken before the market's recent slide, most respondents believe that a correction would be a normal and healthy development. Meanwhile, 60% of respondents believe that U.S. GDP will expand by 3% or more in the next 12 months, and 42% indicate that U.S. stocks are the most attractive asset class, up from 24% in the last poll released in April.

Looking Ahead

"It's probably time to get more defensive," Paulsen told CNBC, recommending that investors look to safety sectors such as utilities, consumer staples, and REITs. He also noted that defensive stocks already have become market leaders, adding, "I think it suggests that economic growth is going to slow more than Wall Street really is ready for." After years of relatively steady gains, investors may be psychologically unprepared for big sell-offs, which may result in ill-considered, panicked decision making that may exacerbate market turmoil.

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