Why Stocks Dropped So Much In October

Why Stocks Dropped So Much In October

From October 1 through October 31 the S&P 500 dropped over 7%. And this came on the heels of a gain of over 9% between the beginning of 2018 and the end of September. Why did this happen? The explanation is quite simple although likely far from satisfactory.

As I have written previously, there are really only two factors that impact stock market performance: company performance (typically measured by net earnings) and investor sentiment. Company performance is easily measurable, although only in hindsight. Investor sentiment, on the other hand, is much more difficult to quantify. We can measure it indirectly through a company stock’s Price/Earnings (P/E) ratio. This multiple indicates the price per share investors are willing to pay for a certain level of company earnings per share. When the stock’s P/E ratio is higher, it is an indication that investors are willing to pay more for the same level of earnings from that company than when its P/E ratio is lower.

The aggregate earnings of the companies comprising the S&P 500 for the first three quarters of 2018 rose about 24% on average, according to Lipper Alpha Insight. During this same period the S&P 500 rose a bit over 8%. One could thus argue that company performance and stock market performance during that time were at least positively correlated.

Now let’s look at investor sentiment. The aggregate P/E ratio for the S&P 500 declined from 32.9 to 30.6 during the month of October. At the same time, Q4 earnings for the S&P companies (so far) indicates no significant declines. Therefore we can conclude that the drop in stock prices was largely caused by a turnaround in investor sentiment.

A simple explanation? Yes. A satisfactory one? No. Most people would prefer to know what caused sentiment to change (and so quickly) so that they can predict in advance the next time it will happen.

Good luck. It’s hard enough trying to predict company performance, even by insiders. Trying to predict how millions of investors will react to the deluge of news, commentary, company reports, conspiracy theories, and just plain lies thrown at us from all the media sources available today is totally futile. Was it something said by some politician during the run-up to the current election? Something that happened overseas? A forward-looking announcement by some S&P 500 company during performance reporting? There is no known way to sift through all the available data to figure out (1) which data contributed and which didn’t and (2) what was the cause and effect.

What should investors do? I’ve said it before. Ignore the ups and downs of the capital markets, whether caused either by economic or investor outlook cycles, and follow instead an investment strategy that balances the risk and return needed to support what you want to do in your future. As long as economic growth continues over the longer term, such a strategy will not only provide for your future but give you peace of mind for the present.

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