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(Editor’s note: Stacy Johnson has been a CPA since 1980 and has also earned licenses in stocks, commodities, options, mutual funds, life insurance and real estate. He spent 10 years as a Wall Street investment adviser and has been investing in both stocks and real estate for more than 30 years.)
Thursday’s stock market decline was the largest this year, undoubtedly creating worries for the millions of Americans with savings exposed to stocks in 401(k) and other investment plans.
If that’s you, take a breath.
There are at least two reasons why this week’s weakness shouldn’t prompt panic.
The economy is healing
The catalyst for the recent decline was the government’s announcement that someday soon — maybe this year, maybe next — it would stop intervening to keep interest rates low. Because stocks, as well as the overall economy, like low interest rates, that’s bad news.
But the good news is the reason the government is cutting back on help: The economy no longer needs it. By just about any metric, from unemployment to retail sales to housing starts, the economy is in better shape than it’s been in for years. When the economy is good, companies make more money. When companies make more money, their stocks increase in value.
Stocks aren’t overpriced
Because the stock market has been doing so well — it’s more than doubled since the lows of 2009 — it’s easy to imagine it’s in bubble territory. But it’s not.
The most common yardstick to measure stock values is the price of shares divided by earnings per share, known as the price/earnings ratio. For example, if a stock is trading at $100 a share and earns $5 a share, its P/E ratio is 20. If it’s earning $10 a share, its P/E is 10. The higher the P/E ratio, the more potentially overvalued the stock.
Based on the Standard & Poor’s 500 index, today’s overall market is trading at about 16 times earnings, slightly below the post-World War II average of 17.5.
Granted, today’s values don’t reflect an undervalued market. But as earnings grow with a healthier economy (see above) that leaves room for stock values to grow as well.
Then why is the market going down?
I just offered two reasons why things are rosy. So why the rout?
First, stocks have been on a tear this year, so some investors will pull the trigger to lock in profits at the drop of a hat. And potentially rising rates are a big hat. In addition, China announced this week that its economy isn’t as robust as believed. As the world’s second largest (behind the U.S.) weakness in China could spill over to the rest of the world, including us.
What’s an investor to do?
If you’re investing for the long term, nothing. Things like Thursday’s sell-off happen. This is the reason stocks have paid more over time than most other types of investments: They’re scary. But for those in for the long term, what happened this week changes nothing.
But weeks like this do offer a golden opportunity for a gut check. If you’re freaked out over your paper losses, take it as an indication you may have too much of your savings in stocks.
Expect more volatility in coming weeks and months. There’s still a lot of uncertainty worldwide and while our economy is on firmer footing, it’s still a bit wobbly. Uncertain times inevitably lead to wild market swings. But then, that’s the way the stock market has always been, and will almost certainly always be.
Lest you think I’m saying one thing while doing another, you’re welcome to check out how I’ve invested my own money. Unlike most investment columnists, I put my money where my mouth is by keeping my portfolio online here.