Panic or pause? The instinct is to sell with everyone else. But there is a good case for calm

NEW YORK, N.Y. – Stocks dropping across the globe. Six weeks of gains wiped out in the U.S. The biggest drop in the Dow Jones industrial average in 1 1/2 years.

It’s easy to give into panic and sell along with everyone else. But there is a good case for staying calm.

Three reasons you may want to hold on to your stocks:

STRONGER ECONOMY: Nothing kills a stock rally like a recession. Four of the five previous bull markets ended as investors sold during a recession, or anticipated one.

Are we anywhere near a recession now? Quite the opposite. The economic recovery seems to be gaining traction.

Americans spent more at stores in May, despite higher payroll taxes. Sales of previously occupied homes last month topped five million at an annual rate for the first time in 3 1/2 years.

Better yet, the jobs picture is brightening. Since October, employers have added an average of 196,500 jobs a month, up from 157,000 a month in the previous eight months. And unemployment, still relatively high at 7.6 per cent, looks likely to head down. The Fed said Wednesday that it could fall as low as 7.2 per cent this year, then down to 6.5 per cent next year.

One warning: Recessions are difficult to predict, so anything is possible.

STOCKS SEEM REASONABLY VALUED: Major U.S. stock indexes have dropped more than 2 per cent this month even though corporate profits are at a record high.

All else being equal, investors who buy now could be getting stocks at a good price.

One way to value stocks is to look at their price-earnings ratio. To calculate a P/E, you divide the price of a stock by its annual earnings per share. A company that earns $4 a share and has a $60 stock has a P/E of 15, for instance. The lower the P/E, the cheaper the stock.

The Standard & Poor’s 500 index is trading at 16.1 times earnings per share over the past 12 months, according to S&P Dow Jones Indices, which oversees the index. The average since World War II is 17.5. Translation: Stocks are slightly cheaper than the long-term average now.

To be sure, there are other ways to value stocks, and not all are as encouraging.

Still, it’s clear that stocks are not wildly overpriced. And if you believe the economic recovery will continue, earnings are likely to grow, too.

CASH APLENTY: Don’t be surprised if companies launch yet another round of stock buybacks, which could lift stock prices. Fewer shares outstanding means higher earnings per share.

The impact of stock buybacks on the market the past four years has been big.

Nearly every other large player in the stock market — insurers, brokerages, state and local governments, pension funds — has been selling. And yet stocks have more doubled from their recession lows. A big reason is that U.S. companies, not counting financial firms, have bought more than $1 trillion of their own stock in the five years through 2012, according to the Federal Reserve.

Depending on your point of view, the outsize role of buybacks is either good or bad.

Skeptics say buybacks show companies don’t have anything better to do with their money, a bad sign for future profits. Stock bulls say it shows that the people who know their companies better than anyone else — corporate executives — think their stocks are a bargain, and so should you.

Whoever is right, buybacks are likely to continue because companies have plenty of firepower. Companies in the S&P 500 have $1 trillion of cash, according to S&P Dow Jones. The cash hoard has never been higher.