Are the major stock markets overdue for correction?

Market moves at the end of last week have prompted discussion of whether the world's major stock markets might be overdue for correction.

Experience shows that markets will undergo a correction, defined as a fall of around 10%, on average once a year. It is now around two years since the UK underwent a correction (mid-2015 according to London Stock Exchange records), suggesting one is overdue, statistically at least.

Technically speaking, the Dow Jones Industrial Average (DJIA) has not had a correction since October 1987 (Black Monday).

The statistics show that many of the major markets fell slightly on Friday (1 December). The S&P500 was down 0.69%, the Nasdaq Composite fell 1.13%, the Dow Jones Industrial Average slipped 0.56%, the FTSE100 0.36% and the FTSE Eurofirst 300 0.74%.

Dipping and sliding

The Hang Seng index was down 0.35% and the FTSE All World $ fell 0.46%. Markets in Mumbai, Korea, Spain, France and Germany also dipped.

From a broader perspective, the DJIA reached an all-time high last week, breaking through the 24,000 mark for the first time ever. And the S&P 500 was still overall up on the week.

There would appear, though, to be little consensus on what happens next. Especially as there have been widespread predictions of crash and correction dating back a number of months.

Valuations look stretched

Some market professionals predict continuing positive movement even while conceding that valuations already look stretched. Some take the opposite view and say a crash will come in equities markets.

Seasoned participants will respond by pointing out that it is the very lack of consensus that makes markets what they are. One investor's rubbish is another's pot of gold. One investor's long position is another investor's short position.

Corrections can present buying opportunities for investors.

Even the professionals, people paid to know about arcane economic matters, and make the right investment calls, disagree strongly, often citing the same underlying facts and figures to justify their own view.

Sound asset allocation

What are we mere mortals to make of this state of affairs? The simple but boring answer is to make sound asset allocation decisions. Spread risk by asset class, geography, sector and individual stock selection. That of course is how professional investment managers earn their money.

Chris Iggo, chief investment officer fixed income at AXA Investment Managers, is by definition a bond specialist. But he has words of wisdom to share on the topic of equities markets and where they might go from their current elevated positions.

In the real world the word bubble is being used more and more in discussions about the US stock market, he says.

However, recent price action set against extremely low levels of volatility means stock investors have rarely had it so good. There is more focus on equities because strongly valued bonds offer little updside, he adds.

“Is this late cycle stuff? Who knows, the economy is certainly not slowing down. But with 20% total returns this year, a bout of profit-taking would not be a big surprise. Profit-taking typically sees markets stopped in their tracks, even reversed, if only temporarily.

Chris Iggo, courtesy of AXA IM

Trump success could drive US stocks

A suggestion spotted elsewhere over the weekend, however, is that President Trump's belated success in pushing through tax reform measures could be positive for US stocks.

It seems that if there is going to be a change in the dynamics, it would come from the equity market, says Iggo. But the economy is strong, strong, strong, he insists, despite misgivings over market valuations.

November’s round of purchasing manager indices (PMIs) points to a strong global manufacturing sector, buoyed reasonable final demand and a strong technology cycle.

Monetary policy a key factor

A key factor in the direction of future valuations is monetary policy globally. While the US Federal Reserve has begun to tighten cautiously, followed even more cautiously by the Bank of England, there is no certainty that others will follow suit.

Indeed, S&P Global Ratings says in its just-issued Industry Top Trends 2018 paper that it expects central banks will continue with accommodative monetary policy for the next year at least.

It points to the absence of inflationary pressures and a pace of growth that remains modest relative to previous cycles. Financing costs are thus likely to remain favourable, barring a substantial repricing of risk premia, it says.

Cyclical versus secular

S&P Global Ratings contrasts the favourability of cyclical conditions with the impact of secular pressures across many industries as digital technology continues its relentless advance.

It highlights several industries as vulnerable, including

• Global retail
• Chemicals
• Media
• Consumer products
• Telecoms
• Autos

It predicts that mergers and acquisitions (M&A) activity will pick up, with potential financial risks. A longstanding rule of thumb is that an M&A announcement will result in a share price rise for the target, but a fall for the bidder.

Too late for Goldilocks

Too late for Goldilocks but too soon for the Bears is the catchy title of a note from Goldman Sachs looking ahead to 2018. It describes 2017 as a Goldilocks year thanks firstly to the twin impact of a dovish central bank policy and a weaker US dollar.

Growth is likely to remain strong but has passed peak momentum, it says, forecasting global growth of 4% and 3.9% in 2018 and 2019 respectively.

“While these conditions make a bear market unlikely in the foreseeable future, they do point to the probability of lower absolute returns through to 2020 as growth momentum slows,” it adds.

Much of which is sharply contradicted by the outlook for 2018 as interpreted by global investment house Schroders. It expects three Fed rate increases in 2018, following on one at this month's meeting, and another in 2019.

This would, though, take the policy rate to only 2.5%, laughably low for those who experienced the monetary horrors of the 1970s and 1980s.

The revival of economic growth in 2017 supports a faster pace of inflation in 2018, says Schroders, unable to resist the temptation to use one of Europe's favourite folk tales to make a point.

Goldilocks fading

“Next year will see a fading of the Goldilocks combination of better than expected growth and weaker than expected inflation,” it predicts.

“Structural factors such as the effect of technology remain important, but cyclical forces suggest that inflation will begin to catch up with the strength of economic activity.”

In conclusion, with equities as with anything else, what goes up will almost certainly go down. And as an oft-quoted market adage has it, it is better to miss the last 10% of a bull market than catch the first 30% of a bear market.