Why Last Week's Market Sell-Off Was a Good Thing

Last Thursday -- Nov. 5 -- was an ugly day for the stock market.

The S&P 500 index dropped 4.4%, the Nasdaq Composite plunged 5.5%, and the Dow Jones Industrial Average shed 1,833 points. Overall, $3.7 trillion of U.S. market value was wiped out in one trading day.

Oddly, the market drawdown was not an immediate reaction to the "blue tsunami" midterm elections, which brought Democratic victories across the nation and will flip both the Senate and the House of Representatives to Democratic control. I say this because the day after the election, markets were up.

Instead, I believe the Thursday pullback was a reaction to stock valuations that are just too high. The Shiller price-to-earnings ratio had reached 41 before the market dip, a high it had seen only once before in history and far above the 32 level seen just before the 1929 crash. So the market was poised to correct and shed some of that excess when a triggering event came along. This time, the primary event may have been the growing realization that congressional Democrats, as well as Democratic governors and state legislatures, could be unfriendly to the data-center build-out on which the artificial intelligence (AI) industry relies.

Image source: Getty Images.

Small forest fires

I believe the Thursday pullback was a good thing. It brings to mind a saying on Wall Street: "Small forest fires prevent large forest fires."

That is, occasional small corrections and pullbacks in the market undo excess and prevent larger ones down the road. They're a normal, healthy way for the market to avoid asset bubbles and reset overextended valuations.

They're also an opportunity: They offer new, more attractive entry points to many stocks that were previously too expensive to consider.

They're extremely common, too. Research by Adams Brown, a business advisory firm, shows that between 1928 and 2024, there was at least one 10% correction per year on average, more than three 5% mild corrections, and about seven 3% dips.

As of this writing, it seems the market was a bit oversold. On Friday, all indexes rebounded, as many investors stepped back in to buy the dip.

Is that the end of market volatility for a while? Hardly. I expect many more seesaw actions in the stock market as investors adjust to the new political reality in Washington and continue to navigate an AI revolution that generates enthusiasm one day and fear the next.

After all, market volatility is the price that stock investors pay for higher returns.

And keep in mind that historically, the six months following a midterm election have been very good periods for stocks. I expect we'll see the same pattern this time. Stay invested.

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