With global equity markets on the back foot, and an element of investor panic creeping in, it's worth stepping back and assessing the broader outlook.

As always our story begins in the US, which to a large degree still drives sentiment in the local market. The US S&P 500 index started to look toppy in early September, and finally succumbed after reaching a closing high of 2011 points on the 18th. At its recent closing low last week, the market was still down only 3.2% from its peak. The market closed down 0.9% overnight and only a whisker above last week’s lows.

In the greater scheme of things, a 3% pull back is still small beer – and would mark the 6th pullback of less than 5 per cent over the past year. The US market’s last decent ‘correction’ was the 9.9% decline in mid-2012, before which it was the larger 19.4% decline in over the second half of 2011.

At 15.3, the S&P 500’s forward PE ratio ended-September at above-average levels – indeed, near the peak valuations in almost 10 years. With the US dollar rising and the prospect of higher US interest rates, the market seems vulnerable to such lofty valuations.

 

As a result, it would not surprise were the market to struggle a while longer – with prices either falling into deeper correction territory, or at least treading water for a time allowing the growth in earnings to drag market valuations back to more reasonable levels. The last two decent US market corrections pulled the forward PE ratio back into the 10-12 times earnings range. I would be more comfortable with the market were valuations once again back in this range.

What of Australia? Note our market started falling a little ahead of the US this time around, with the S&P/ASX 200 index peaking at a closing high of 5658 points on 2 September. By the time the US market peaked, the local market had already pulled back 4 per cent.

Assuming our market matches Wall Street’s overnight decline and falls by around 1% today, it will break though recent closing lows to be down about 7.5% from recent peaks. Accordingly, this would be the worst pull back since mid-2013, but still not as bad as the 22.6% slump in mid-2011.

At 14.4, the local markets forward PE ratio ended last month also at above average levels – but less so than in the US – and local valuations have meandered around current levels for the better part of a year. Local earnings have been far less impressive of late, due to both consumer cautions, the higher $A and falling commodity prices.

Unlike in the US, however, our currency is now falling rather than rising – aiding international competitiveness – while interest rates, already higher than in the United States, are likely to remain on hold for longer than those in the US. At least relative to the US, our earnings outlook might start to improve.

That said, Australia is relatively more exposed to the fear of rising global interest rates and the continued slump in commodity prices – given we’re top heavy with financial and resource stocks. And recent history suggests our market tends to sell of more heavily when Wall Street corrects. The weaker $A is also encouraging foreign investors to head for the exits.

Where does this leave us? If the US market continues its retreat – as seems likely – our market can’t help but follow. Indeed, as in the US, valuations are likely now a little too rich for comfort, and we could see better buying levels again with the PE ratio back below 12 or so.

How bad could it get? A sell-off to the last significant low in December 2013 (around 5100 points) would constitute a reasonable 10 per cent correction, while fall back to the mid-2013 (around 4750) lows would constitute a 16 per cent correction – significant, but still a little less than that seen in 2011. Based on today’s forward earnings estimate, a drop in the market to 5100 points or 4750 points would reduce the forward PE ratio to around 13.5 and 12.5 respectively. This is not out of the question.

Note, moreover, our market’s rally has had waning momentum (as reflected in a downtrend in the weekly RSI or ‘relative strength indicator’) and a true correction low might be found once this finally drops to 'oversold' levels of around 30. It is currently still hovering just under 40.

All up, I would not be hurrying to scoop up bargains just yet. But nor would I to jettisoning my long-term holdings out of fear we’re re-entering a new sustained bear market. What we’re likely seeing is yet another cyclical correction in the market as the global economic recovery from the financial crisis matures, creating global currency and interest rate re-alignments.

Markets have now raced a little too far ahead of earnings, and need to price in the risk of higher US interest rates. Balance will be restored once valuations are back at more comfortable levels.