Our Thoughts on the Stock Market Correction

The 3% drop in the stock market on February 27th does not change our constructive view for equities for the full-year 2007, but is a reminder of the short-term volatility that one can sometimes endure as a long-term investor. Stock prices had been unusually quiescent since bottoming last summer, with the S&P 500 gaining 18% in an almost uninterrupted advance. The relatively modest pullback (at least so far) wiped out the gains from earlier this year, but the market is still well above the lows of last July.
Perhaps the biggest risk the market faced going into the correction was complacency. After many months with little volatility, investor sentiment had become exceptionally bullish. This can lead to short-term sell-offs in the face of even a little bad news. The precipitating events this time were comments by former Federal Reserve chairman Alan Greenspan that the economy might (not will) tip over into recession later this year, followed by an 8% drop in the Chinese stock market – which had been on a tremendous tear. Once a little fear entered into the US market, it fed on itself, with stocks at one point down over 4% during the day before rallying toward the close.
Our generally optimistic view for 2007 is not based on a particularly strong economy or the requirement that the Federal Reserve aggressively cut interest rates. Rather, we believe that the most likely scenario this year is a slowing of GDP growth to around 2% (this is actually a bit lower than what the Federal Reserve itself is predicting), and only a bit of expansion in corporate profits. The key driver of the market in 2007 is unlikely to be earnings growth, but a belief that stock values will rise for a given level of profits. This trend began late last year. A slowing but not stalling economy with no further interest rate increases is the kind of market environment that has supported an expansion of equity valuations in the past. Also, mortgage rates will continue to fall in response to any weakness in the economy or stock market, providing much-needed support to housing and consumer spending.
Having said that, it may take awhile for the market to find its footing. Past corrections of this size, particularly after a long period of strong returns, have generally not led to a quick rebound in prices. So we may see some more pressure on stocks in the short run, but as the year continues to unfold the overall developments should be positive.