Stocktake: Is a market correction looming?

Sentiment, valuations and earnings momentum suggest a time for caution

Elevated sentiment invariably follows strong price action and there’s no doubt that price action has been explosive for some time now. The S&P 500, for example, is up almost 80 per cent since bottoming last March.

With valuations suggesting stocks are expensive and indices appearing technically overbought, investors might wonder: is a correction around the corner?

A 10 per cent correction seems "very plausible", Citigroup's Tobias Levkovich cautioned last week. Levkovich doesn't envisage a bear market – US stocks are not in bubble territory, stocks are exiting rather than entering a recession and rates are not rising, so comparisons with the 2000-2002 bear market are ill-advised, he says.

Nevertheless, several factors (sentiment, valuations, reducing earnings momentum) suggest this is a time for caution, says Levkovich.

Tricky business

Double-digit corrections are certainly common – there have been 36 since 1950, says Ritholtz Wealth Management's Ben Carlson. The problem is that timing them is a tricky business.

In recent decades, stocks have gone between four and seven years without correcting – think 1990-1997, 2002-2007, and 2011-2015. If you were waiting for a correction, you would have missed out on big gains; the S&P 500 advanced 302, 112 and 109 per cent during those respective periods.

Being psychologically prepared for a correction is all very well, but don’t forget that market timing can, as Carlson notes, be a “destructive exercise” with a “massive opportunity cost”.