We Had the Correction: Now What?

The third quarter of this year was a weak one for the markets.  After experiencing the first correction in more than four years, S&P 500 declined by 6.9% for the quarter in a highly volatile environment.  The index is down by the same amount year to date.

Despite strong volatility this quarter, I think that the markets actually behaved rationally over the last several months.  Back in April, I wrote, “For the next couple of quarters, earnings are expected to stay flat or even decline, and that may make it difficult for the market to advance.  While there is no bubble to speak of, we may finally get that long-awaited 10% correction.” That has proven to be correct.  The earnings this quarter are expected to decline by about 4%, driven by primarily two factors: low oil prices and corresponding crash in earnings of energy companies, and continued headwinds of strong U.S. dollar.

If we exclude the energy sector whose dismal results dragged down the overall S&P 500 bottom line, we will find out that many industry sectors (such as technology, for example) continue to grow earnings.  The euro appears to have stabilized against the dollar; in fact, I think that Q3 is the last quarter to have poor year-to-year comparisons due to currency issues.  Assuming continued relative stability of the dollar, the currency headwinds due to prior year comparisons will decrease substantially in Q4 and disappear completely by Q1 of next year.  The dollar-denominated earnings of U.S. multinationals will benefit accordingly.  As markets are always forward-looking, this should have a positive effect on share prices.