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Major stock crashes have a reason

Most of the major corrections in stock markets were associated with factors external to the stock market.

The S&P 500’s forward price-to-earnings ratio is currently at a level of 16.6x, which is half a standard deviation above its 25-year historical average of 15.6x.

Many investors may think that higher valuations suggest that a bear market is imminent.

But this is not necessarily the case.

In a article on J.P. Morgan Asset Management’s Insights blog, James Liu and Abigail Dwyer argue that bear markets often result from factors external to the stock market, such as recessions, wars and credit bubbles.

They share a chart showing that there have been ten pullbacks of approximately 20% or greater since the 1920s. Most of these ten major corrections were associated with factors external to the stock market, like wars, recessions, and monetary policy shifts.

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According to Liu and Dwyer, the current economic backdrop is strong and poised to continue strengthening:

“U.S. economic growth is steady and the labor market is improving at an accelerating pace. Corporations are healthy and are finally putting cash to work. Consumers are more confident today than even just a year ago, as household net worth rises and gasoline prices fall, but they are not euphoric by any means. Investor sentiment is also rising, but is still below the levels of irrational exuberance seen during the tech boom.”

Finally all bull markets must eventually end. Liu and Dwyer simply aren’t seeing the worrisome trends—such as valuation ratios high above their historical averages, collapsing profit margins or higher inflation—that have often preceded prior market corrections.

“Instead of trying to time the next market correction, investors should stay diversified to protect one’s portfolio against unforeseen market shocks”, analysts say.

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