What you should know about the recent market drop

NEW YORK - OCTOBER 07: A trader rubs his face while working on the floor of the New York Stock Exchange October 7, 2008 in New York City. The Dow fell more than 500 points despite a government debt buyouyt plan. (Photo by Mario Tama/Getty Images) Mario Tama

(MoneyWatch) Most likely, you've seen how stocks have been clobbered over the past few days. The S&P 500 index has dropped almost 8 percent since its May 21 close of 1,669, the highest of the year. Bonds haven't been immune to tough market conditions either, with yields soaring in recent weeks. The 10-year and 30-year Treasury yields ended April at 1.70 percent and 2.88 percent respectively. Yesterday, they closed at 2.57 percent and 3.66 percent, respectively.

However, what you may not have seen are some of the positives we've been experiencing lately. My almost 20 years of providing advice to individual investors have taught me that it's relatively easy to stay the course when things are going well, but we tend to stray from the disciplined and winning strategy of buy, hold and rebalance when things get rough. This is why it's important to see both sides -- the whole picture helps investors to stay the course. Here are some of the positives to keep in mind.

Housing

The housing industry is rapidly improving. Home prices jumped a whopping 12.1 percent in the past year, according to the S&P/Case-Shiller composite index. The supply of homes for sale in most markets is now below normal levels. That's creating bidding wars in some markets. And even if interest rates were to rise a further 1 percent, they would still be well below historical averages.

Interest rates

The steep rise in the yield curve is a boon to banks. Along with the strong housing market and an improving economy, this should be very positive for profits. Given that housing and banking were at the epicenter of the financial crisis, investors should welcome the news that these sectors are doing well.

Energy production

Environmental concerns aside, the new fracking industry has caused a significant revitalization in U.S. energy production. Natural gas production is up about 30 percent since 2005.

Unemployment

The unemployment rate ticked up slightly from April to May, but it was still down 0.6 percent from one year ago. Forty-two states saw decreases in their unemployment rates over the same one-year period.

Municipal budgets

In most cases, state and local governments have taken strong actions to strengthen their fiscal situations. Another major concern has faded: Meredith Whitney's forecast of hundreds of billions in municipal defaults is now a distant memory.

U.S. deficit

The U.S. government's deficit is coming in well below forecasts thanks in part to the housing boom, which is driving record profits for the now-government-owned Fannie Mae and Freddie Mac. Other bailout programs are also generating profits.

Corporate profits

Overall corporate profits continue to be strong. Economist Edward Yardeni reports that the current full year operating earnings forecast for the S&P 500 Index is expected to come in at around $111. With the S&P 500 closing at 1,573 yesterday, that's a forward-looking price-earnings ratio of about 14.1, or a little more than the historical average. Stocks certainly don't look expensive -- even if forward-looking estimates are notoriously optimistic.

Money supply

Despite all the concerns about the Federal Reserve's easy monetary policy, M2 (a broad measure of the money supply) has grown at a rate of less than 5 percent over the past three and six months and less than 7 percent over the past 12 months. The market certainly doesn't expect to see any sign of an inflation threat on the horizon, as the breakeven inflation rate on 10-year TIPS is only about 2 percent. And the current consensus forecast of professional economists is for a 10-year inflation rate of just 2.3 percent. Since the market's estimate of inflation has not risen, the sharp rise in interest rates has been caused by a rise in the real rate.

Quantitative easing

Fed Chairman Ben Bernanke's statements about the tapering of the quantitative-easing program was accompanied by the caveat that it would be carried out only if the economy continued to improve and that he fully expected that the Fed would continue its policy of zero interest rates well into next year. In fact, he indicated that the Fed would continue that policy until the unemployment rate fell to perhaps 6 percent, a lower figure than previously indicated.

The bottom line is that we saw the stock market fall sharply because of concerns about rising interest rates. However, the rise in rates was based on a stronger economic outlook, which is good for corporate profits, which in turn are ultimately what drives the stock market. It wasn't based on a rising inflation outlook, which would be negative for stocks.

Of course, I don't want to mislead you by presenting a one-sided picture. As is always the case, there are plenty of negatives to worry about -- if you think that would be a valuable use of your time:

  • There's the sharp slowing of the Chinese economy.
  • There are riots in Brazil and Turkey.
  • There's civil war in Syria, which threatens the entire Middle East.
  • Let's not forget our budget deficit and the continuing threat of a default on our debt if Congress doesn't act before the end of the year.
  • And of course there are concerns about the impact on business of the Affordable Health Care Act and other activities of the Obama administration that are considered anti-business.

But it's important to understand that if you know about these issues, so does the rest of the market. And that's why the market is selling at only about 13.5 times expected earnings. In other words, it's not that the market has to go down because of the negatives. It's that it would be a lot higher if the negatives weren't there.

So what should you do about all this information? Assuming you have a well-developed investment plan, you should do nothing, as your plan should have anticipated that environments like this would occur. If you don't have a plan, I suggest you go pick up a copy of "The Only Guide You'll Ever Need to the Right Financial Plan," read it and then develop, write and sign your plan. And then have the wisdom and discipline to stay the course.

  • Larry Swedroe On Twitter»

    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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