The current S&P 500 drawdown looks consistent with a healthy correction in an ongoing bull market. The market was overdue for one. As I wrote in October: "I think a deeper drawdown (e.g., 10-15%) or several months of sideways consolidation would be a healthy development for the medium to longer-term prospects of the bull market."

From the beginning of last year to last week's close, the S&P 500 forward earnings multiple fell from 27.0 to 19.9, a 26% decline. Meanwhile, the market was up 17% over that period. Valuations are now back to 2017 levels.

As I wrote in my June 2020 report: "P/E ratios (both forward and trailing) tend to spike coming out of recessions. Forward P/E spikes as forward 12-month earnings estimates drop and the market prices in a recovery further out. And trailing ratios spike as realized trailing earnings drop. After post-recession spikes, P/E ratios tend to come down as earnings grow faster than the market rises, lowering the multiple."

Chart

One of the biggest concerns in the market today is Fed rate hikes and quantitative tightening (QT). In the last cycle, Fed QT was likely a contributor to the Q4 2018 correction, but it's worth noting that the market regained momentum and made new all-time highs despite ongoing balance sheet reduction.

The last QT (2017-2019) reduced the Fed's balance sheet by 15% over a two-year period, going from $4.5T to $3.8T (a $700B reduction at an average pace of about $30B/month). The balance sheet is currently about $8.9T - so 15% would be $1.4T. $2.5T would likely be the max reduction given that the Fed won't want to reduce bank reserves below $1.4T (currently at $3.9T). $2T of US Treasuries are maturing over the next 24 months. That might imply a max monthly run-off pace of $85B/month on average if everything was allowed to mature without reinvestment. MBS (mortgage-backed securities) are long-dated but frequently pre-paid. The Fed would likely prioritize MBS reduction over US Treasuries. QT is expected to start in the second half of this year.

The ECB and BoJ are together continuing QE at around $70B/month, so anything more than $70B/month in Fed balance sheet reduction would likely start to reduce the aggregate G3 central bank balance sheet.

Notably, the dollar hasn't been able to sustain upward momentum since late November, even given the continued hawkish pivot from the Fed and downside volatility in risk assets. A weakening dollar should support international equity markets.

Medium-term, a review of the data suggests the market outlook continues to be supported by the ongoing economic expansion and a remaining wall-of-worry to climb. As always, the outlook requires constant reassessment. And everyone needs to put probability and reward-to-risk assessments in the context of their strategy, process, and time horizon.

The Merk Hard Currency Fund is a no-load mutual fund that invests in a basket of hard currencies from countries with strong monetary policies assembled to protect against the depreciation of the U.S. dollar relative to other currencies. The Fund may serve as a valuable diversification component as it seeks to protect against a decline in the dollar while potentially mitigating stock market, credit and interest riskswith the ease of investing in a mutual fund. The Fund may be appropriate for you if you are pursuing a long-term goal with a hard currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Fund and to download a prospectus, please visit www.merkfund.com. Investors should consider the investment objectives, risks and charges and expenses of the Merk Hard Currency Fund carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Fund's website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest. The Fund primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Fund owns and the price of the Funds shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Fund is subject to interest rate risk which is the risk that debt securities in the Funds portfolio will decline in value because of increases in market interest rates. As a non-diversified fund, the Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. The Fund may also invest in derivative securities which can be volatile and involve various types and degrees of risk. For a more complete discussion of these and other Fund risks please refer to the Funds prospectus. The views in this article were those of Axel Merk as of the newsletter's publication date and may not reflect his views at any time thereafter. These views and opinions should not be construed as investment advice nor considered as an offer to sell or a solicitation of an offer to buy shares of any securities mentioned herein. Mr. Merk is the founder and president of Merk Investments LLC and is the portfolio manager for the Merk Hard Currency Fund. Foreside Fund Services, LLC, distributor.

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