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Despite sharp selloff, too early to worry about a correction

A Wall Street sign is pictured in the rain outside the New York Stock Exchange in New York June 9, 2014. REUTERS/Carlo Allegri/Files

By Angela Moon

NEW YORK (Reuters) - Wall Street's worst week in two years was enough to get investors worried about whether a long-overdue correction is coming, but analysts are still leaning bullish.

The S&P 500 ended the week down 2.7 percent, its biggest weekly loss since June 2012, a decline that had followed several weeks of selling.

The market is undoubtedly ripe for a correction - the current rally has continued for nearly three years without a decline of more than 10 percent. The Fed looks closer to raising rates, and housing and auto sales figures suggest those markets may be softening, if only temporarily.

"The summer has been just tough because there has been very little to buy," said Kathleen Gaffney, portfolio manager of the Eaton Vance Bond Fund. "But I think what is happening is we are seeing the markets adjusting from an environment of lower interest rates to higher interest rates – and that's producing volatility."

The Federal Reserve's monetary policy has been favorable for the markets, and though the Fed is expected to begin raising rates next year, the absence of wage pressures has kept moves in Treasuries yields relatively muted.

While the spread between long- and short-dated Treasuries has narrowed of late, which tends to happen as the economy slows, the difference between the two-year and 10-year Treasury notes is more than 2 percentage points - still a favorable sign for economic growth.

On Wednesday, the Federal Reserve gave a rosier assessment of the U.S. economy while reaffirming that it is in no hurry to raise interest rates. The U.S. central bank also, as expected, reduced its monthly asset purchases to $25 billion from $35 billion.

Although government data on Friday showed U.S. job growth slowed in July and the unemployment rate unexpectedly rose, recent economic data has been largely positive with growth in second-quarter gross domestic product at 4 percent and favorable revisions to first-quarter GDP.

The CBOE Volatility index (.VIX), Wall Street's so-called fear gauge, jumped to 17.03 from 12.69 after Portugal's Banco Espirito Santo reported an unexpectedly large loss for the first six months of the year that raised concerns about the bank's solvency and after U.S. employment cost pressures came in higher than anticipated.

But the VIX remains well under the long-term average of about 20, and stock valuations remain reasonable. The S&P 500 (.SPX) is trading at an average price-to-expected earnings ratio of 15.4, which is not very stretched relative to the historical average of around 14.1.

"The economic environment remains healthy. As such, volatility should decline and stocks should rebound," said Jonathan Golub, chief U.S. market strategist at RBC Capital Markets.

Even so, the fact that the benchmark S&P 500 hasn't been able to crack the 2,000 milestone despite a few approaches suggests some exhaustion is setting in.

(Additional reporting by Jennifer Ablan in New York and Nandi Kaul in Bangalore; Editing by Leslie Adler)