Time For A Stock Market Correction?

There is a large cottage industry of people who habitually called for a crash in financial markets. Some of these perma bears likely do so on the basis that such wild market calls are going marketing ploys, and others are of a permanently negative disposition.

Perma bears

Others may simply look at broad fundamentals – grand thematic levels indicators such as the ratio of stock market capitalization to GDP (a preferred Warren Buffet indicator) or the ratio of world debt to GDP, or an array of valuation measures for corporate securities (for example valuations for indebted companies have never been so high in recent decades and bond spreads for very risky corporate debt) and become (easily) convinced that asset prices are too high and vulnerable.

This, above view is convincing in the sense that it sets up the argument that future investment returns will be low, but long term valuations measures are of little help in gauging tactical market moves.

October since we had a correction

In this context a few observations are worth making.

The first is that the S&P 500 index has not had a 5% (or more) correction in over eight months, something that is historically unusual. Indeed, there have only been five occasions in the past twenty years when markets have gone for longer without a correction. So, time is finally on the side of the bears.

In addition, when in the past the stock market has risen by 10% or more in the first half of the year, it has usually finished close to or just above high levels in December, but often had a summer drawdown.

Sentiment stretched

Behaviour in the options market reinforces this. While overall volatility has been falling to below long term average levels, skew in the market – which shows what time of options investors prefer – is at an extreme, showing that some (institutional) investors are preparing for a market sell off.

Add to this the fact that many risk appetite indicators (that measure whether investors are buying risky or safe assets) are at historically high levels and that market volumes have been low, then the outlook for equities points to a tactical, rather than catastrophic correction (sorry perma-bears).

Investors can hedge portfolios, move partly to cash and importantly stand back and rethink the underlying drivers of the stock market.

Central banks the key

The one factor that looms here is central banks. They, notably the Fed, have responded forcefully and generously to the financial side-effects of the COVID crisis, but their actions are creating imbalances in terms of severe wealth inequality, and growing signs of inflation.

To date most central bankers have passed these signs of inflation off as transitory, and market have chosen to believe them. Any signs – Fridays jobs data is important here – that higher inflation is proving more sticky will produce greater volatility across financial markets.

The trouble today is that investors are not positioned for this at all, which makes it all the more likely that we see a stock market correction very soon.

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