A Correction Is Healthy

A host of factors have recently been pressuring the stock market. The S&P 500 Index has nearly doubled from its bear-market low in March 2020, signifying one of the strongest 16-month gains in post-war history! After such a robust, uninterrupted advance, it simply feels overdue for a correction. Moreover, compared to historical norms, valuation measures portray an extremely overvalued market.

The Federal Reserve has recently been “talking about talking about” tapering, and the annual growth in real M2 money supply has collapsed from almost 26% in February to less than 9% in May. In addition, legislated tax hikes on corporations and the wealthy seem to be coming soon. Maybe it is merely “transitory,” but the inflation rate continues to surge higher, and economic reports are no longer blowing away expectations. Indeed, concerningly, some numbers are now coming in weaker than expected, and for the first time since June 2020, the U.S. Citi Economic Surprise Index has fallen to near zero.

Furthermore, COVID-19 is again raising its ugly head. The more transmissible and virulent Delta variant is increasing case counts around the globe, causing concerns about renewed economic shutdowns. Finally, what does the bond market know that could eventually scare stock investors? Last week, the 10-year bond yield collapsed to about 1.25%—retracing almost 0.5% of its early-year advance.

Facing so many hurdles, it would not be at all surprising if the U.S. stock market is headed for a correction. Nonetheless, although painful, corrections are an integral part of bull markets. They reset valuations, check excessive investor optimism, and slow policy tightening—establishing a stronger foundation for a bull’s next leg. Investors should prepare for a potentially rocky road ahead but also stay focused on what may come after a potential temporary setback. Despite all the challenges, today’s specific economic character is relatively rare and historically positive for stock market returns.

Although not unique, it is uncommon for the stock market to suffer a fall-off after the 10-year bond yield has been declining for three months; and it is now lower than it was almost five months ago. Corrections generally commence with a peak in bond yields—not after they have declined significantly. It is also unusual to face corrective pressures when the consensus looks for S&P 500 EPS to rise substantially over the next few quarters. At present, the S&P 500 trailing 12-month EPS is about $142, while the 2021 year-end consensus is for $192 EPS. That is, S&P 500 earnings are anticipated to surge nearly 35% between now and the end of this year.

The combo of lower yields with sizable fundamental gains (e.g., EPS, real GDP, incomes, and jobs) has historically proved very profitable for stock investors.

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