Posted by Shyam Moondra
The DJIA has gone down by 550 points in just two days, the largest two-day decline this year. Last Wednesday, Federal Reserve announced that, for now, they would continue to buy mortgage-based securities and Treasuries at the rate of $85 billion a month; however, the Fed also said that they were prepared to phase-out the QE program later this year if the unemployment rate fell to around 7% from the current 7.6%. The Fed announcement also pushed the yield on 10-year Treasuries to 2.42%, the highest since 2011. The announcement was hardly a breaking-news; everybody understood that if economy strengthened, the Fed would phase-out QE to ensure that inflationary expectations did not get out of control. It's almost as if the investors had already decided to dump both stocks and bonds regardless of what the Fed said. The expiration of stock options this week may have also contributed to this unexpected market crash. Interestingly, gold, silver, and oil prices also crashed, suggesting a total panic among the investors. They would rather hold on to cash and earn close to zero interest or less than the inflation rate, thereby losing ground in terms of real value.
When faint-hearted investors panic, smart investors aggressively move in and start buying good quality stocks at fire-sale prices. The crowd is so much focused on the tapering of QE and rising interest rates that they are completely ignoring the reasons behind the Fed's QE policy. As the Fed Chairman Ben Bernanke explained in his press conference on Wednesday, if the Fed started to taper off QE it would be because of improving underlying fundamentals of economy. An improved economy means higher sales and profits for corporations and that, in turn, means higher stock prices. Since corporate balance sheets are the strongest ever (with the current cash hoard of $5 trillion), they don't really need to borrow much to support their capital investment programs and are thus relatively unaffected by higher interest rates. Also, as Bernanke pointed out at his press conference, increase in mortgage interest rates would not necessarily reduce the demand for housing because the increase in monthly payments would be relatively small. Let's not forget that the current levels of interest rates are no where near the normalized levels that existed before the 2008 financial crisis. Therefore, investors' worries over increasing interest rates are somewhat overblown.
The current stock valuations are very attractive. The WSJ reports that the current estimates of forward PE for DJIA is 13.62, S&P 500 is 14.88, and NASDAQ is 16.22. It's hard to imagine a huge selloff at such low PE ratios at a time when economy is strengthening. If economy continues to improve, as the Fed expects, corporate profits will also increase and these estimates of PE's could in fact prove to be too conservative. At previous market peaks, we have had PE ratios in the high 20's to low 30's range. While no one expects that we would get back to those levels any time soon, the current PE ratios are hardly excessive to have triggered a huge selloff.
This is the time to buy stocks of high quality companies that are positioned to experience growth in revenues and profits as the economy improves. The current market crash may have created one of those rare opportunities for the long-term investors who tend to buy and hold stocks. Also, as the interest rates rise, the bond bubble will finally burst and some of the bond money will end up in equity funds, creating one of the greatest rotations of recent times. In fact, the DJIA could very well hit 18,000 within a couple of years.
This is not the time to panic - this is the time to buy quality equities for the long-term.
