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Stocks could fall a lot further

<i>Brendan McDermid/Reuters</i><br/>
Brendan McDermid/Reuters

By Paul R. La Monica, CNN Business

Stocks have been tumbling all year. The Nasdaq, down nearly 25% in 2022, is in a bear market. The S&P 500 is on a six-week losing streak and about 16% below its all-time high.

But could stocks still have a lot more room to fall?

Some would argue that the brief, Covid-induced bear market in the spring of 2020 didn’t do much to change investor sentiment.

If anything, generous pandemic stimulus may have made the speculative mania even worse. It seems that many people used some of their government cash to trade meme stocks, cryptocurrencies and other risky investments. But shares of companies like GameStop and AMC as well as bitcoin and other cryptos have been crushed in 2022.

The CNN Business Fear & Greed Index, which looks at seven measures of market sentiment, has been showing signs of Extreme Fear for the past week.

Despite this, the broader market may still not have reached the proverbial point of capitulation, the widespread feeling of surrender among investors that often signals a bottom. After all, the S&P 500 is still trading about 20% above pre-pandemic levels.

More selling could be in the cards before the bear market runs its course

So stocks may need to drop a lot further before the market finally hits bottom, especially since the Federal Reserve seems intent on raising interest rates more aggressively to fight inflation — no matter what happens to stocks.

“The current combination of an exceptionally strong labor market and excessively high inflation increases the likelihood that the Fed will stay the course on rate increases — even if the S&P 500 falls into bear market territory,” said Gavin Stephens, director of portfolio management at Goelzer Investment Management, in an email.

“History shows that the Fed will tolerate large drops in stock prices if conditions warrant it. Those conditions are in place today, meaning that we should not expect the Fed to come to the stock market’s rescue at this time,” he added.

The good news for investors is that stocks are now much cheaper than they were before this year’s market slump. According to data from FactSet, the S&P 500 is now trading at about 16.6 times earnings estimates for this year. That’s below the five-year and ten-year averages for the index.

But stocks may be “cheap” for good reason. Earnings for the first quarter are up only about 9% from a year ago, the slowest growth rate since the fourth quarter of 2020.

Profit growth is expected to dip further in the near term. Earnings are expected to climb only 4.4% in the second quarter, according to FactSet. And more Fed rate hikes will take their toll on earnings.

“It doesn’t feel like it’s time to call the bottom yet,” Christopher Smart, chief global strategist and head of the Barings Investment Institute, said in a report. “Until markets gain comfort on the path of long term rates, investors won’t be able to agree on a definition of what is cheap.”

That said, trying to time when the market has hit a bottom — or a top — may be a fool’s errand. Many experts argue that investors with diversified portfolios will be better off if they don’t panic.

“You could miss the best rebounds if you stop investing because of a potential downturn. You run the risk that the market will go up while you’re waiting on the sidelines,” said Tony Molina, product evangelist at Wealthfront.

“It’s important to remember that volatility is a normal part of investing, and you don’t actually lose any money unless you sell your investments for less than what you paid for them,” he added. “History shows that markets tend to rise in the long run, which means if you stick to a diversified strategy and keep investing, you’re likely to come out ahead.”

In other words, the storm clouds may not be ready to part for stocks just yet. But just as rainy days eventually give way to sunshine, patient investors can count on another bull market run once this volatility subsides.

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