We can't see what's around the corner for stocks, but when we hear that valuations are high, markets are volatile and the economy on a knife edge, we prepare for losses – and a possible correction.
Equity markets in the US and Europe have been steadily marching higher since February 2009, which on the FTSE 100 in London, marked its financial crisis low point.
Over time, equity markets move higher. They suffer periods of losses, but in the long term, they move higher.
Bear market vs correction
Large reversals – of more than 20% measured from the most recent peak – we call "bear markets".
These happen infrequently – the last bear market was during the 2008 financial crisis. The one before that was the 2000 bursting of the dotcom bubble.
Smaller reversals – of more than 10% but less than 20% – are "corrections", so called because they are seen as more of a market "reset".
They are marked by more targeted bursts of profit taking rather than secular, wholesale sell-offs.
Corrections tend to last a few weeks or months, whereas bear markets can last years. The dotcom bubble bear market started in January 2000 and lasted until January 2003.
Corrections happen much more frequently. On the FTSE 100, four since the end of the financial crisis: in 2010, 2011, 2012 and 2015. On the S&P 500 in the US, also four: in 2010, 2011, 2014 and 2015.
"Equity markets are volatile, and while deep bear markets are relatively infrequent, corrections are a regular feature," says David Jane, fund manager at Miton.
Given the frequency noted above, it would seem equity markets are due a correction.
"Clearly, equity valuations are high, and in certain areas, extremely high, particularly for internet companies," says Jane.
But, he adds, valuation is not a good indicator of future market returns in the short term, and it would likely take disappointing news on the economy to cause profit expectations to wither.
Reading the signs
So, what are the important signals to look out for in the coming weeks?
- Economic data while not stellar, appear to be recovering some poise following a slower first quarter. But any signs that areas of weakness are developing – manufacturing weakness for example – would start to ring alarm bells.
- Volatility, as measured by the Vix index, has remained low – mostly below 15 – since the surprise election of President Trump. Corrections tend to occur when regular spikes above 25 occur.
- Inflation in the major economies is benign and so there are few reasons for central banks to tighten monetary policy. If prices, however, were to start rapidly rising, rates may be raised more quickly than markets are prepared for.
- Corporate earnings have largely beaten forecasts during the first quarter, any sign over the summer that second-quarter profits are falling short could drive investors out of equities.
- The summer. The old market mantra of sell in May and go away till St Leger day can be prescient. Of the four corrections on the FTSE 100 mentioned above, three were during the summer months when activity and trading volumes are low.
One sign that the conditions may not be right for a correction is the rise in corporate confidence. Companies are increasingly embarking on share buybacks using large amounts of leverage.
Buying back shares and retiring them helps strengthen the share price – many companies which believe their shares are undervalued participate in buybacks. So this would seem to counter the notion that valuations are high.
"Buybacks are recovering now that profits are returning, banks closer to ending the post crisis capital raising and still cheap credit as QE tapering commences," says Karen Olney at UBS.
Look out too for other signs that business confidence is rising, says the UBS analyst.
"M&A activity appears to be picking up and even capital expenditure which has been one of the most elusive data in this recovery is now showing initial signs of strength again."
Of the risks on the horizon, the biggest worry is of a shock to the markets during the summer – a period of higher than usual volatility due holiday absences lowering trading volumes.
Bert Colijn, senior eurozone economist at ING says that because risk events like the French and Dutch elections passed without too much market disruption there was much relief in the markets, and while the economy looks robust a near-term correction does not look likely.
"We're in a bit of sweet spot for markets with inflation being so weak," he says.
He warns of risk events to come – ECB tapering, Italian elections, Greek debt renegotiations - all have the potential to deliver that surprise that markets so hate.
"These could still have a negative impact if the markets aren't pricing them in over the coming months," he says.
But with inflation low, economic recovery likely, strong corporate earnings and robust business confidence, this doesn't appear to be a market on the verge of a correction.
Let the summer madness prove us wrong.