July 15, 2014


Is the Market Due for a Correction?

We have seen high returns and low volatility over the past three years. It feels like the stock market is due for a correction. Over the past three years returns have been much higher than average and volatility has been much lower than average. The chart below compares returns, and the variability in returns, for the S&P 500 over various periods. Annual returns over the past three years, at nearly 17%, are well above the long-term average of about 10%, while variability was only two-thirds of that experienced historically. By way of contrast, the three-year period leading up to June 2009 was a disaster for returns, but volatility was merely average.

Performance of S&P 500 Index Over Various Periods

Different views of the future. When stocks are appropriately valued, it means that the pressure for higher valuations is roughly equal to the downward pressure on prices. Some think the future will bring faster growth in sales and earnings, while others hold an opposing view, but the equilibrium price includes an expectation that investors will earn a return on their capital over the long term.

Let’s consider some offsetting views. It is easy to tick off reasons why markets could, or should, correct. The P/E ratios have risen above historical averages, indicating overvaluation. The economy remains fragile and very dependent on the Federal Reserve. Emerging markets are struggling and growth has slowed in China. Europe and Japan are still struggling to get on their feet, and then we have all the volatile geopolitical issues of the day from Syria and Iraq to Russia and Ukraine, not to mention North Korea, and the turmoil in most of central Africa.

So why are the markets continuing to push the Dow and the S&P 500 indices to new record highs? Well, one thing to keep in mind is that the normal course of economic expansion should result in stock values growing and, therefore, constantly reaching new record highs. As investors, most of us are tainted by the experience of the past two decades, when the technology bubble of the late 1990s inflated stock values so much and so fast that it has taken 15 years to straighten out. Microsoft is a good example of how far out of whack valuations were at the height of the tech bubble. It is trading now at around 15 times earnings, which is near the long-term market average for all stocks. Back in 1999 the price reached a level that was over 80 times earnings. Paying 15 times earnings is more likely to generate an acceptable rate of return.

Other factors contributing to a positive outlook for stocks include the fact that the US economy is growing, with no signs of overheating or significant imbalances. There is a lot of promising new technology on the horizon – think 3-D printers. The energy boom is pushing the US back toward energy independence, which provides a wide variety of related economic and political benefits.

Conclusion – expect lower returns and more volatility. We should expect lower returns than the past five years and more volatility, but a major correction, while always possible, seems no more probable now than at any other time.

Of course, a significant correction is quite likely at some point, but it would represent a bump in the road for long-term investors who can expect market forces to provide adequate risk-adjusted returns over time.

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