A Rational Outlook On The S&P 500: Correction Not Justified (NYSEARCA:IVV)

The S&P 500 index is expected to retain its current valuation with potential for upside. Investors should aim to maintain a rational outlook amidst any further drawdowns. As such, investors should continue to hold the related ETFs (Vanguard 500 Index Fund ETF: VOO, iShares Core S&P 500 ETF: IVV, and SPDR S&P 500 ETF Trust: SPY) or act on opportunities to increase their position. To minimize expenses, VOO is the superior ETF amongst the available products as noted in the analysis by a fellow Seeking Alpha author.

Following a tumultuous trading day with the S&P 500 dipping into correction territory before pulling into the green by end of day, the market is rife with fears about the expected trajectory over the next few days. Many foresee a further crash leading up to the FOMC meeting and potentially beyond driven by discussions of a rate hike and the impending end to the current bull market. We look at several reasons why today’s flash crash to the S&P 500 was an overreaction and why investors should continue to hold and act on opportunities to buy on dips.

Rate Hike Not Likely Until March

The recent volatility in the S&P 500 is largely due to expectations of a rate hike at the next FOMC meeting. This is highly unlikely to occur.

As noted in the last FOMC meeting in December 2021, the market’s expectation for the first increase in the target range at the time was moved from the first quarter of 2023 to June 2022 (as determined based on the Open Market Desk’s survey of primary dealers and market participants). Currently, the fed funds futures market is pricing in the first rate hike of 25 bps for March 2022.

The federal reserve minutes outlined a commitment to, “keep the target range for the federal funds rate at 0 to ¼ percent until labor market conditions had reached levels consistent with the Committee’s assessments of maximum employment, a condition most participants judged could be met relatively soon if the recent pace of labor market improvements continued.” It was also noted that several FOMC participants viewed labor market conditions to be consistent with maximum employment.

The FOMC meeting minutes are typically vague with room for interpretation. However, reading between the lines, it can be speculated that at the time, the FOMC viewed that the labor market was approaching maximum employment, but not quite there. In the jobs report following the December FOMC meeting released on January 7, 2022, the unemployment rate declined from 4.2% to 3.9% in December, a modest improvement unlikely to justify an immediate increase in the federal funds rate.

Based on the above, we expect that at the upcoming January FOMC meeting, the messaging will be more direct regarding maximum employment and a rate hike in March; however, we believe it is highly unlikely for the FOMC to surprise the market with a rate increase now amidst the ongoing Omicron wave.

Economy is Robust

As outlined in the FOMC minutes of the December meeting, aggregate demand was strong in the fourth quarter of 2021 with GDP expected to remain in an upwards trajectory over 2022 consistent with the continued reopening of the economy and recovering supply chains. Reviewing several economic indicators released in the past month, there is no indication of any contradictions to the positive economic outlook (i.e., last month saw an increase in mortgage applications, building permits, and housing starts). Meanwhile, inflation, largely driven by global supply chain bottlenecks and domestic labor shortages as a result of Omicron, should slowly taper as the impact of the variant eases.

Summary of Expected Impact on S&P 500

A positive economic outlook, easing of Omicron, and slow and steady Fed normalization policy would point to the S&P 500 and related ETFs to remain at the current level. Consensus analyst earnings for S&P 500 is 223.61. This projection at the current S&P 500 forward P/E of 19.6 would translate to an S&P index valuation of 4,383. If the index recovers to the median forward P/E of 20.1, an S&P valuation of 4,495 would be realistic (a 2% upside to the index and related ETFs). A return to forward P/E levels of mid-20s is also not out of the question if market sentiment improves. Exposure to the S&P 500 through any of the ETFs is a prudent play with potential continued upside.