This has been a very unusual year in the capital markets — all three major U.S. stock market indices have reached all-time highs, high yield bonds have posted impressive gains and long-term interest rates have touched an all-time low, while safe haven assets like gold and bonds have posted impressive rallies. And all of this has occurred amidst a backdrop of slowing U.S. and global economic growth and weakening corporate earnings.
With these conflicting signals being sent simultaneously by both risky and safe haven assets, GuideStone believes a near-term correction in stocks is very possible. We certainly aren’t recommending that investors sell stocks today, because market timing doesn’t work; however, we do believe it’s always good to be prepared, even when the best plan is to stay the course.
So, why is a correction likely?
- Earnings: The U.S. economy has only grown 1% this year, while U.S. corporate earnings have now fallen for five consecutive quarters. U.S. stocks are also currently pricing in a 13% increase in earnings next year, which is very unlikely. At some point, the stock market will likely have to adjust to reflect a lower level of 2017 earnings than investors currently expect.
- Interest rates: Risk assets are being driven by the decline in long-term interest rates, which is a function of aggressive global central bank policy. This was exacerbated following the surprise Brexit vote, when central banks went into overdrive to offset the feared economic impact of the decision. As a result, capital markets worldwide are now very dependent on this historically low level of interest rates, both short and long term. So any unexpected change in policy that raises the level of rates would likely cause a sell-off in the equity markets, which is something to watch for when the four major central banks, including the U.S. Fed, meet in September.
- Investor complacency: Equity investors today are very complacent and do not seem to fully appreciate the risks in the market. Specifically, the volatility index (VIX) is at a multi-year low, while investor optimism is on the rise, which has historically been a sign of a market top. Importantly, the complacency we are seeing today is very similar to the investor sentiment witnessed prior to last August’s 12% stock market correction, when the economic and earnings backdrop was stronger than it is today.
- Uncertain macro environment: A variety of macroeconomic events could serve as the catalyst for a correction, including developments in the U.S. presidential election, progression toward the U.K. exit from the European Union (i.e., Brexit) and/or a rapid depreciation in the Chinese currency, which was the trigger for the last two downturns in the market. With complacency as high as it is, it wouldn’t take much to trigger a sell-off. And don’t forget that September and October tend to be historically bad for stocks.
GuideStone does not anticipate a recession in the near term, nor do we think it’s likely that interest rates rise materially, so an equity bear market (i.e., prolonged decline of 20% or more) is not in our forecast. However, corrections of 10% or so are normal and healthy, and the environment is ripe for one today. It’s important to note that we have made it through two 12% corrections in the past 12 months, so if one occurred in the near term, it would probably signal nothing more than a necessary phase of the market cycle.
In any event, timing the market is not a sound strategy, while successful long-term investors have the patience and prudence to ride out such inevitable downturns without overreacting. However, now may be a good opportunity to review your risk tolerance and time horizon to ensure your portfolio allocation is appropriate for your unique circumstances.