With Stocks in a Correction, What Investors Need to Remember

stock market plunge
stock market plunge

If you were waiting for a full-blown, honest-to-goodness, technically accurate "correction" in stocks, then congratulations: It's here. The Dow bled out another 377 points Thursday, and the benchmark S&P 500 ($INX) is now off more than 10% from its most recent high.

A week of relentless selling has stocks sitting at levels not seen since February, and more worrisome, they haven't really gone anywhere in six months. Naturally, the reason for today's worldwide pounding of equities remained unchanged: The financial crisis in Europe is hammering the euro and lifting the dollar as anxiety mounts that the global economic recovery is in peril.

But in times of heightened volatility it's critical for long-term investors not to mistake the trade for the trend. True, even Ed Yardeni, the bullishly prescient president of Yardeni Research, is getting a bit hinky these days, but he's hardly giving up on stocks. "I've turned increasingly defensive since early May, but held on to my bullish yearend targets," Yardeni told clients amid all the market madness.

A "Paralyzing" Focus

After all, the fundamentals haven't changed yet. First-quarter earnings season is all but over, and the results were historically outstanding. The S&P 500 is about to beat estimates at the greatest rate since 1987, when such data starting getting tracked. Moreover, earnings are coming in more than 15% above analysts' expectations, and all 10 sectors of the S&P 500 have posted year-over-year profit and sales growth.

It's not that the situation in Europe might deteriorate further. What long-term investors need to decide is whether the market has adequately discounted that risk. If you look at trailing earnings, the answer is probably yes. As Jeffrey Kleintop, chief market strategist at LPL Financial, recently told clients: "Focusing on the short-term can be paralyzing for many investors. History shows us that what really matters is the price we pay, not so much what happens along the way."

And just what are investors paying for stocks in this punishingly corrective environment? The market's trailing price/earnings (P/E) multiple (which measures actual earnings, not estimated ones), dropped to 13.3 Thursday, according to Bloomberg data. That's the cheapest the S&P 500 has been since March 2009 -- at the very bottom of the bear market.

Buying When Stocks Are on Sale

Surely corporate growth prospects are better now than they appeared back then. That's why the longer-term trend to the upside remains intact.

"P/E has a nearly perfect track record of forecasting long-term performance over the past 20 years or so," Kleintop writes. "Based on P/E, investors should have felt confident of long-term gains and have been putting money to work in the stock market over the past year."

Indeed they should. Fidelity Investments, the giant, privately held asset manager, said Wednesday that the average 401(k) account balance rose more than 40% over the last year. Why? Because investors were buying stocks when they were on sale even as the bigger picture made equities look doomed.

In short, when everyone is fearful, it's time to be greedy, especially if equities have been beaten down beyond reason. Says Kleintop: "This simple predictive relationship between P/E and return gives us hope that it is not different this time."