531 Pt. Drop – Market Sell Off Explained in Simple Terms

by Jack Lee

There were a number of factors that gave investors the jitters going into this week, but that turned to panic when China announced they were going to devalue their currency and suddenly we closed down 531 pts on Friday. China’s economic power is running neck and neck with us, so the world is paying very close attention to any negative news coming from
China.   Prior to the devaluation, Chinese Officials claimed their economy grew at a whopping 7% last year, but few believed it.  This credibility gap linked to the news about the Yuan started our lasted market rout, but there was a bit more to it:

Historical Reference: On Black Monday in 1987 the Dow fell 508 points and that represented a 22 percent decline. Our 531 pt. drop on Friday was only half as bad because the major indexes are much higher than they were in 1987. What we really saw for the week was a loss of about 10%.

One reason for this downturn (correction) was stock prices have continued to climb even as company’s revenue growth has been flat. So, whether it was China, Greece or something else…a correction was to be expected. That’s the good news, but only if this is a [correction]. Corrections are defined as lasting two months or less with less than a 20% drop in average share prices.

If you are concerned about your position in the market, here’s an important benchmark number for you to be watching, 2000 on the S&P…got that? If the S&P closes out the month below 2000 this could be a signal we’re in for more selling and if this drags on too long we could be facing a bear market and not a correction.

Good News – Bad News: Corrections in the market place serve a good purpose, because when stock prices inflate to an uncomfortable ratio between its price and actual earnings a bubble begins to form. We saw that happen in the real estate market a few years back. Corrections let some of the air out before a bubble can get too large.

Right now stocks are trading a bit out in front of earnings making them inflated, meaning more room for the correction. The S&P 500 is trading 18.2 times its earnings averaged out over the past 12 months and prudence says it should be trading roughly around 16.5 to 17.5 times earnings.

History says the worst case scenario could take us all the way down to 11.5 X earnings, as it did in 1988.  Consider this a worst case scenario, but it’s unlikely we’ll get anywhere near that level unless the news in China is worse than they are telling us.   That part, the keeping us in dark about the true state of their financial woes, will no doubt continue to be a drag on the market.  Until we see their market leveling out, it’s wise to keep a close watch on our market.  Don’t be too quick to go bargain hunting because bigger bargains could be around the next drop. Oh, and if you read other ratios, that are higher than mine, keep in mine they are probably adjusted earnings.

Let me underscore the above with these words of wisdom: “There’s a lot of systemic fear with growth slowing in China … but nobody really knows what the actual data is,” said John Caruso, senior market strategist at RJO Futures. “With China taking the drastic measure of actually devaluing their currency (last week) many people are believing things are much worse than they’re leading us on to believe.”