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Why A Market Correction Should Not Be Feared

As we head into yet another earnings season many investors are acutely aware that the market looks a tad expensive.

That reality has hit home over the past two weeks as many of the leading growth stocks in the market have rolled over.  This is especially true with high-profile Internet and tech stocks that led the charge into 2013.

However, while many of these high-profile stocks have been hit hard, the broad market has actually held up quite well and is essentially flat on the year. Given the volatility of late and the 5% decline in the month of January, I think that’s pretty good.

But let’s get back to valuation because that’s what we should be focused on right now. And as we roll into earnings season, revisions to forward estimates are likely to set the tone for the rest of the year.

As Q1 earnings and forward guidance for many companies arrive in coming weeks, analysts are going to update their earnings estimates for 2014. If earnings estimates are revised downward, that will amplify the fact that the market is overvalued. That would be bad.

If analysts revise earnings estimates upward for 2014, that will alleviate the degree to which the market appears overvalued. That would be good.

This is where we are now…

The forward 12-month P/E ratio for the S&P 500 sits at 15.5, based on the consensus forward 12-month EPS estimate of $119.10. How does this compare to the S&P 500’s historical averages?

Data from FactSet shows that the index currently trades above both the 5-year (13.2) and 10-year (13.8) average P/E ratios.

S&P PE

To put this in context, we would need to see a 10% decline in the S&P 500 for the index to trade back in line with its 10-year average forward P/E ratio, assuming no revisions to forward estimates are made.

However, if forward earnings estimates are revised upward by 12.5% to $134, then the market would be trading in line with its 10-year average valuation.

So where does this leave us? What’s the takeaway message?

It’s unlikely that forward earnings estimates will be revised up to $134. We’re likely to see earnings at that level in 2015, but not 2014. And on the flip side, I don’t think a 10% correction is off the table. We haven’t had one since early 2012 when the S&P 500 dropped by 9.9% over a 59-day period.

The reality is that the market is a little stretched, based on valuations. That should come as no surprise. We also know that markets can trade at a premium for an extended time, but eventually, they will come back in line as either prices go down or earnings go up.

My advice is that you be prepared for a 10% market correction, but don’t expect one. The fact is that nobody can predict these things with any degree of accuracy. It’s simply prudent to be prepared given the facts on the table.

This doesn’t mean sell stocks if you’re a long-term investor. Market corrections are a healthy thing, and often represent a buying opportunity for those committed to stocks over the long haul.

As the chart below from Yardeni Research below shows, we’ve had five significant corrections since 2008, and the market is at record highs. If you fled stocks prior to any of these, you’ve missed out on one of the greatest bull markets in history.

yardeni Market Corrections

I continue to recommend investors sell stocks that they don’t have very specific reasons for owning and that they don’t want to hold through market turbulence. I’d rather see investors hold cash instead of stocks that they’re just not sure about. In other words, review your portfolio and cut the fluff — cash is always good.

And I continue to recommend stocks that offer attractive risk vs. reward profiles based on specific catalysts, dividend growth and/or attractive valuations. Naturally, the specific stock in question dictates the reason.

Over the coming weeks we’ll be able to piece together a more accurate earnings estimate for the S&P 500 in 2014. While the market looks a bit expensive right now, I still expect the S&P 500 to rise by 5% to 10% in 2014.

That rise will be powered by 8% to 10% earnings growth, and there will be ample opportunities for investors to make money in quality stocks, whether we get a 10% correction or not.

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