The blue-chip index fell 335 points, or 2%, to 16,659, while the broad S&P 500 dropped 41 points, or 2.1%, to 1,928.
After hitting multiple record highs over the summer, some investors might view these declines as a surprise, but those who looked under the markets hood saw the slump coming weeks ago by examining small-cap stocks in the Russell 2000 index.
That index is down just under 12% from its June peak, which is officially correction territory, defined as a 10% drop in a major stock index.
The Russell is down 8.5% year-to-date, compared to a 3.7% rise in the S&P 500.
“That divergence means investors were hiding out in the large cap stocks, keeping the Dow and S&P propped up, but underneath the surface it was eroding away,” says Dan Wantrobski, director of technical research at Janney Capital Management.
Still, the latest selloff in stocks doesn’t point to a bear market just yet, defined as a 20% drop or higher. The S&P 500 is trading at about 16 times earnings and Wantrobski sees a markets peak once the index is valued in the high twenties, which he says could take several years.
“That said, in a bull market we allow for severe corrections, especially like the one in 2011, where the S&P 500 dropped 19% from August to October,” he adds. “A correction is healthy for the market until it turns into a bear market.”
The 2011 correction was the last one to hit the markets, leaving some to wonder if we are overdue for another one. Stock market pullbacks allow for buying opportunities.
“I’m telling clients to take 20% of their cash and start buying,” says Scott Wren, senior equity strategist, managing director at Wells Fargo Advisors. “We want our clients to be assertive, but not overly aggressive.”
Wren is overweight in sectors that are sensitive to the continuation of the recovery in the U.S. and abroad, including industrials, consumer discretionary and technology. He doesn’t think it’s time to act defensive by pouring money into staple stocks or utilities.
Jeff Sica of Sica Wealth Management isn’t shopping for stocks now but is watching energy stocks that have been underperforming as of late, which could present buying opportunities. “I think there’s no doubt we’re going into a correction,” he says. “I’m of the belief the market has been so dependent on quantitative easing and never built up stability on its own.”
The Federal Reserve began to taper its bond stimulus, known as quantitative easing, to the tune of $10 billion each month since the start of the year and will end the program this month, leaving the market without training wheels for the first time since the recession.
Given the economic woes in Europe, the European Central Bank is trying to take a page out of the Federal Reserve’s playbook by devising its own form of quantitative easing earlier this month, which has helped keep stocks high in the U.S., but will be tougher to implement in Europe, given the variety of currencies and economies. Some countries in Europe are doing better than others, so prescribing one medication to the entire system could backfire.
In Europe, there is growing concern over deflationary pressures, or falling prices. Deflation is a threat to economic growth, as consumers tend to postpone purchases with the hopes of scoring a better deal in the future, but economies depend on continuous consumer spending. The hope is more central bank intervention via quantitative easing will spur much needed inflation in the region.
“Investors are under the anticipation that quantitative easing in the U.S. would end and begin in Europe making for a smooth transition,” Sica says. “That’s not going to happen and a recovery in Europe, if any, will be long and painful, as the high expectations of a quick fix in the region are coming to an end.”
To make matters worse, Europe’s strongest economy, Germany, has been facing issues. On Thursday, German export data was released, showing a 5.8% decline in August, compared to July. “This makes you question the stability of Europe,” Sica adds.
- Written by Scott Gamm for MainStreet. Gamm is author of MORE MONEY, PLEASE.