The Stock Market Is About to Come Crashing Back to Reality. And That’s a Good Thing

• Political bickering over more stimulus could cause an 8% drop in the S&P 500.
• Any way you look at it, the stock market seems overvalued.
• A pullback now is good for the long-term prospects of the stock market.

The U.S. stock market ticked higher Monday following reassurances from Federal Reserve Chair Jerome Powell over the weekend. But as investors have seen over the past few weeks, the upside is limited. Not only that, but the chances of another significant dip are growing larger.

Powell Admits the Future is Unclear

Over the weekend, investors latched on to Jerome Powell’s promise  that the Fed has more than enough tools to support the nation’s economy in the coming months. What they didn’t seem to digest, though, was the fact that Powell underscored the length and severity of this economic downturn, saying he believes it will take years for the U.S. to recover fully. 

This economy will recover. And that means people will go back to work. Unemployment will get back down. We’ll get through this. It may take a while. It may take a period of time. It could stretch through the end of next year. We really don’t know

It’s that last bit that investors should be focused on—“we really don’t know.” With that in mind, how can you accurately price the coronavirus into sharemarkets? You can’t.

Stock Market Valuation Is Worrying

That’s where the stock market’s valuation comes into question. Bulls would argue that as a forward-looking indicator, the stock market is choosing to see past the turmoil caused by coronavirus. But considering that not even Jerome Powell can accurately guess when the economy will recover, investors may be in denial.

According to FactSet, the S&P 500 is trading at 20 times its future earnings . That’s well above the five-year average of 16.7 and the ten-year average of 15.1. That’s also higher than the market’s forward P/E of 19  back in February. 

The full economic impact of coronavirus has yet to reveal itself. We will likely learn more from the upcoming personal income data for April.

Most are expecting the report to reveal an uptick in total income  despite rising jobless figures. That’s because the government has stepped up in a big way over the past month with unprecedented stimulus. But those stimulus dollars are about to dry up, and then what?

Stimulus Checks Held Up in Washington

Lawmakers are currently arguing over what the next steps will be , with Democrats pushing another massive stimulus offering and Republicans arguing for a “wait-and-see” approach.

Jason Woodard from Bank of America said the standoff could take the S&P 500 down to 2,650 , or 8% from current levels. He believes the stock market is expecting more stimulus; without it, valuations could plummet. 

When the government requires a shutdown of economic activity, the logical corollary is for the state to provide the support for what’s lost. If it’s a quarter of GDP, so be it. If it’s two quarters, so be it. The alternative is a depression.

Market Decline Is Good for Long-Term Investors

An 8% decline in the market is a step in the right direction.  That’s because, at some point, the U.S. stock market needs to reflect the reality of the U.S. economy .

Many believe the jobless rate will remain in the teens  at least through the end of 2020. Imagine all of those people with no jobs and no more additional stimulus watching the companies that used to employ them grow their share price to all-time highs.

Stocks are already trading at the same levels they were at last summer. Back then, unemployment was below 5%, and consumers were free to shop as they pleased.

It’s not going to end well. At some point, the stock market will have to adjust to the economy. If it doesn’t, policymakers will be forced into punishing the market with strict corporate tax laws, capital gains taxes, and even changes in the way dividends are taxed. Those kinds of long-term adjustments would lead to depressed valuations for a much more extended period.

By contrast, if the market is trading lower alongside a depressed economy, there will be less pressure to make Wall Street pay. That scenario would allow investors to buy in at a more reasonable price without the added risk that tighter regulation adds.