With the broad U.S. stock market averages regularly hitting new highs, the chorus of naysayers grows louder by the day. The arguments for an “imminent correction” are compelling: high valuations, rising geopolitical tensions, the onset of tighter monetary policy, and the simple fact that we haven’t had one in a long time. Toss in a horrendous first quarter U.S. GDP, renewed nervousness over the tenuous European economic situation, and the fading, but still painful, memory of the 2008-2009 crash, and it is easy to see why investors are on edge.
Seasoned investors will remember former Fed Chairman Alan Greenspan’s December 1996 observation (in an otherwise mundane speech to a group of economists) that the stock market might be exhibiting “irrational exuberance” because of its high valuation levels. The comment sparked a widespread sell-off in equity markets around the globe, including an immediate 2% drop in the S&P 500. While Chairman Greenspan may have been on to something, the stock market proceeded to tack on three more years of 20%+ returns before the bubble burst in March 2000.
The point of this story is to remind investors of just how difficult it is to predict the direction of the stock market, particularly in the short run. Faced with the question “will we have a correction?” – your advisor should respond with an unequivocal “yes.” Be highly suspicious if your advisor tells you exactly when it will happen.
Stock market corrections are impossible to forecast. The number of things that could initiate a short-term selloff are too numerous to ponder, including something as unpredictable as a change in investor sentiment. It is true that stock market valuations are high, bond yields are low, and there is a lot of money sloshing around the system (courtesy of the Fed) looking for a home. But as Chairman Greenspan unwittingly demonstrated, high valuations do not always signal the onset of a decline. Neither does the length of time between corrections: in the 1990s the S&P 500 went 1,928 days without a 15% decline; we are currently at 658 days.
What is worth considering are the reasons for the decline, the potential extent of the fall, and what happens afterwards. A severe decline in the stock market (defined as a fall of 20% or more) usually precedes an economic recession by six to nine months. Recessions are typically brought about by high interest rates, a sharp spike in oil prices, or a collapse in some important segment in the economy (e.g., housing). Other more shallow declines could be brought about by a number of factors. Differentiating between the two is critical to investment success.
At City National Rochdale, we are ever mindful of the possibility of price declines in any asset class. We continuously monitor a range of economic indicators to gauge the strength of the global economy. At this point, we see no evidence of a pending decline in the U.S. economy, the most important determinant of U.S. stock prices. Could the market crack even if we are right? Sure. Could we be too early, leaving investors on the sidelines as the market moves inexorably higher? Ask Chairman Greenspan.
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