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Stock Market Drops 2.2% And Nears Correction Of 10%; Should You Worry?

Never before has Wall Street gotten off to a worse start to a year, the Associated Press reported Friday, after the stock market plunged 2.2%.

At the close of stock trading on Friday, the Standard & Poor's 500 stock index was down almost 10% from its most recent December 29 -high, and the financial media was filled with pictures of bears and dire predictions.

The market's concerns are the same as they were last August, when the stock prices corrected by more than 11%. Three fears are haunting the stock market: China's economic weakness, the devaluation of the yuan to make China's export less expensive to foreigners, and the specter of a global economic slowdown, if not another "Asian contagion," such as in 1997-1998.

Some scary reports started showing up in the media early in the week. Even institutions were getting in on the gloom-fest, with Royal Bank of Scotland, a global giant, issuing an announcement recommending investors everything but bonds.

As an onslaught of pessimism is likely to be unleashed in the financial press in the days ahead, here are four fundamental economic facts to keep in mind and not fall victim to all the emotion likely to be on display.

Fed Policy Is Not Restrictive. Recessions start after the yield curve — the difference between short-term is inverted. The chart below shows the last three recessions since July 1983 — areas shaded in gray — did not begin until the Federal Reserve inverted the yield curve. Before each recession, the Fed pushed short-term rates higher than long-term rates, leading the way toward recession. Currently, the yield curve is nowhere near inverted. We are very likely to be years away from restrictive Fed policy.

Leading Economic Indicators Are Up. Historically, this set of 10 of the best forward-looking economic indicators of the U.S., the economy turns lower well in advance of onset of a recession. Typically, the LEI drops coincide with a drop in stocks. However, as this data from December 17 by the Conference Board indicate, the leading economic indicators experienced a significant uptick. It makes no sense that a recession is coming. The LEI typically turns negative before a recession. It is going up.

Stocks Are Not Expensive. The red line is the price-earnings ratio of the Standard & Poor's 500 index. The black line shows the price on the S&P 500. At closing on Friday, the S&P 500 stock index traded at about 16 times earnings expected for 2015, and 14.8 times the earnings expected in 2016. Historically, in a low-inflation environment like we are in now, stocks trade at about 17 times earnings. While the stock market may be slightly undervalued, it is certainly not expensive by historical standard. The dotted line, while not a prediction, indicates the path that the S&P 500 could reasonably take, given the current outlook for economic growth and earnings growth coupled with continued expected low inflation. The red line would pull the black line up.

No Sign Of Irrational Exuberance. Irrational exuberance has been in evidence in previous stock market tops. According to the University of Michigan's Sentiment index, sentiment lately has been normal. Look at previous market bubbles. Sentiment index was high. Not now.

A stock market correction can happen at any time, and instances of past performance cited here are not a guarantee of our future results. For now, however, the economic fundamentals don't support the dire predictions and scenarios in the media in times of heightened fears.

1 Estimated 2015, 2016 and 2017 bottom-up S&P 500 earnings per share as of January 4, 2016, was for 2015, $117.26; for 2016, $126.91; for 2017, $142.80. Sources: Yardeni Research, Inc. and Thomson Reuters I/B/E/S survey of consensus estimates. Standard and Poor's for index price data through January 15, 2016; and actual earnings data through 2015.

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This article was written by a professional financial journalist for Houston Asset Management and is not intended as legal or investment advice.

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