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Kent Thune

Why an S&P 500 Correction is Healthy Now

By February 5, 2013

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As I recently reported, last month was the best January for the S&P 500 since 1997. However, the attraction to stocks may have been a bit premature or overdone and a pullback in price would be healthy at this juncture.

For those investors who employ fundamental analysis, the S&P 500 Index began the year at what most investors would consider "fair value" at roughly a 15.00 price to earnings (P/E ratio), according to my Morningstar Principia Pro mutual funds software. During the month of January 2013, the S&P 500 climbed 5.18%. An oversimplified and logical conclusion might be that stock prices need to fall around 5% to return to reasonable levels.

By definition, a market correction is a short-term stock market trend where stock prices fall 5-20% over a relatively short period of time, such as a few weeks or up to several months. For comparative reference, a bear market trend is a more prolonged downward trend in stock prices of more than 20%.

If you use, the S&P 500 Index P/E ratio as a buy or sell signal, I would be careful in present market conditions to place much weight on that strategy. At current valuation, it is difficult to see stocks entering a full bear market or even a correction above 5.00%; but for a healthy bull market to continue, a correction at or below 5.00% is something both fundamental investors and technical analysts might welcome.

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