How Deep Is the Hole the Stock Market Just Stepped In?

Pothole or abyss?

After the Dow Jones industrial average index shed 1,175 points on Monday, extending a rout that began in earnest last week, investors will be wondering what size hole the market has just fallen into.

Of course, it’s impossible to tell exactly where a bottom is, but there are ways to assess whether a sell-off will gather steam or burn out.

Nearly all the economic news has been good in recent weeks, but in the often-neurotic world of investing, the news has perhaps been too good. Two reports last week that wages are growing at a solid pace, for instance, helped prompt the latest selling.

Investors fear that an increase in wages, especially at a time of low unemployment, might lead to higher inflation, which in turn could prompt the Federal Reserve to increase interest rates more quickly than expected. The higher borrowing costs would then crimp companies’ investment plans, leading eventually to lower economic growth overall. There is no evidence that this chain reaction has begun, but when the stock market is in a skittish mood, it does not wait around for the next economic release.

The market will stop sliding when investors start to see bargains and start buying in earnest. But on certain measures, stocks are still expensive.

One way to value companies on the stock market is to compare their share prices with their earnings. If, say, a company made a dollar per share last year and its stock trades at $20, it has a price-to-earnings multiple of 20. As the market kept rising in recent months, investors were willing to pay a high price for companies’ earnings. And even after Monday’s plunge, stock valuations still look demanding. At its peak in January, the Standard & Poor’s 500-stock index traded at 23 times the 2017 profits of the companies in the benchmark. That multiple was well above the average of 19 times for the past five years. If the S&P 500 traded at 19 times 2017 earnings, it would be 10 percent lower than Monday’s closing level of 2,649.

But there is a more optimistic approach that looks at what companies will make in the future. Now, earnings expectations are bullish, with Wall Street analysts expecting companies in the S&P 500 to increase their profits by more than 20 percent. Applying a valuation of 19 times expected 2018 earnings suggests that the market has already sold off too much. But the danger with that approach is that it depends on companies actually delivering those stellar profits. And any sign of a widespread earnings disappointment could set off more selling.

Steep and prolonged stock market sell-offs become particularly dangerous when they spread fear through other markets and weigh on the financial system and the wider economy. On that front, it is worth noting that a closely watched index of the S&P 500’s volatility, a gauge of fear known on Wall Street as the Vix, more than doubled Monday. Bond markets have also been hit by selling. At times like this, professional investors, especially those using borrowed money to make their bets, can report shock losses, adding to the climate of fear. And consumers, long buoyed by the rising value of their stock investments, may cut back spending.

But there are some grounds for optimism. The financial system has far more protection against losses than it had in 2008, which means it can withstand hits itself and should have the strength to keep serving clients through a rocky period.