As you already know, markets have gyrated wildly over the last two weeks. While suspicions of crisis have developed, the market has behaved as if crisis were already upon us.

Broad measures of volatility recorded record gains last week, market mechanics fractured at the Monday, Aug. 24 open and ETF prices became dramatically disconnected from underlying value.

And yet, there have been no national defaults like 1998, no financial defaults like 2008, and no systematic market defaults like 1987.

This dramatic drawdown, to date, amounts only to a crisis of confidence. Market actors abruptly lost confidence in the Chinese, the Fed and global economic growth…or perhaps we should consider the inverse. Perhaps investors previously held too much confidence in the Chinese, the Fed and global economic growth.

An overconfident market expresses itself through prolonged periods of low volatility and rising valuations. On point, the VIX volatility index since the end of 2013 depicts a market lulled into complacency by friendly central banks and slow, but earnings-friendly, inflation-free GDP growth.

Over this time, S&P 500 valuations rose 29 percent, from 14.73x operating earnings to 19.04x, yet at the same time, trailing annual operating earnings grew only 12 percent.

When valuation gains exceed earnings gains, the market signals rising confidence in the future, while simultaneously becoming more susceptible to negative surprises.

The devaluation of the yuan on the Aug. 11, and follow on weak manufacturing readings out of China, presented the market with such a surprise.

Within an instant, confidence levels corrected, taking prices with them.

After peaking near 2,130 in late July, the S&P 500 bottomed out last week around 1,860.

Over the last 12 months the S&P 500 index posted constituent earnings of $108. Therefore, a 108-point loss in the S&P 500 deducts 1 point from the market multiple.

The 270-point loss in the S&P 500 therefore translates into a 2.5x decline in valuation, otherwise known as confidence.

Who knows where the market will ultimately settle? What we do know is that the 2.5x decline in valuation definitely burned off a good deal of overconfidence.

Of course, this logic only works if you hold earnings constant, which we have. We do not believe that we are entering an earnings-crushing recession.

This decline looks like a correction of overconfidence….not a harbinger of recession. The risks of China slowing and the Fed fumbling are not new; they are just now being taken seriously.

Bottom Line

We view the current market correction as a sensible reduction in overconfidence rather than the beginning of a more ominous economic, earnings and market collapse.

Share prices will need time to regroup, so expect this volatility to continue through the remainder of the third quarter.

However, the sharp sell-off does provide the opportunity to rotate into more desirable themes, on sale.

In the melee, we boosted our European, U.S. financials and energy weightings, which had become oversold, in our opinion.

Should history repeat after this sharp sell-off, prices could be significantly higher a year from now, even if they drift lower nearer term.

David Waddell is president and CEO of Memphis-based Waddell & Associates.