As we push forward with this relentless period of calm in the markets, it’s natural to start asking when will it end?
It will at some point, but timing markets is impossible which is why I’m 100% systematic with my investing.
So it’s not constructive to start guessing when it will happen, but that doesn’t mean we can’t discuss the more common reasons for why stocks see corrections in the first place.
And I should note, market corrections are not a bad thing. In fact I would argue they are not only healthy for markets, but necessary for future gains. If market bulls really want this party to continue higher, I would say a little 5-7% pullback might allow that to happen a little easier. Small corrections within the context of larger bull markets is what keeps optimism rising.
So this article is certainly not bearish or doom and gloom. A correction would in no way shape or form mean the bull market is over. But let’s talk about a few of the major reasons why markets correct:
1) Extraneous events. Geopolitics, terror attacks, natural disasters, things like that. Sometimes things completely outside the realm of the economy or the markets can spur a sell off. Impossible to predict of course, but regardless of how positive things may look it’s always important to keep in mind how quickly things can change. If nothing else it keeps us grounded and focused on risk management and position sizing.
2) Fiscal policy. As much as I try to avoid political discussion, politics does influence markets. Especially if there are major policies being discussed or perhaps voted on. Things like repealing Obamacare, passing a budget, raising the debt ceiling, signing an overhaul of the US tax code, referendums and elections. Things like these that have major consequences in peoples lives naturally can cause either positive or negative outcomes in the stock market.
Right now the main focus is tax reform. If we view “the market” as the average buying behavior of market participants, any outcome on the tax front that goes against what the average are hoping for, that may be a catalyst for a correction. It does seem to me that most Americans are hoping for meaningful tax cuts in the coming days / weeks. If that turns out to fail, or if the tax cuts turn out to be not what they were sold as, it could be met with disappointment.
3) Monetary policy. While it’s certainly not a direct correlation or causation, in general as interest rates rise it makes stocks less attractive on a relative basis. So in a rising interest rate environment we should expect market corrections from time to time.
The Fed has raised interest rates 4 times since the financial crisis. Far too little if you ask me, but it’s widely believed that they will raise rates again at their December meeting. They’re also beginning the unwind of the 4.5 trillion dollar balance sheet they’ve amassed, which again on balance could be viewed as negative for stocks. It’s no guarantee, but as rates rise it does increase the probability of a correction.
Noteworthy as well, President Trump is expected to name Powell as the next Fed Chairman so it’ll be interesting to see how markets react to the news and what that does to the plans for a December rate hike and the scheduled unwinding of the Fed balance sheet.
4) Earnings. This could be a dedicated blog article on it’s own because there’s certainly a difference between actual earnings and just earnings expectations or projections. These days I’m definitely noticing more weight being given to the latter than perhaps I’d like to see, but it’s important to follow the flows of money and like it or not perception matters a lot in these current markets so we need to pay attention to projections and estimates. Right now analysts seem to be pricing in strong continued growth as well as benefits from tax reform passing. While this may turn out to be accurate, it certainly increases the possibility of a few missteps along the way.
5) Valuations. I’ll probably go through a chart by chart analysis of valuation in the coming weeks so I won’t talk much about this today. When valuations get stretched, the reasons for continued buying become less. It’s not an exact science and it’s not a fast moving reaction either, but in the medium to long term valuations do matter.
6) Emotions / pure exhaustion. Sometimes markets just correct because it’s time for a correction. It can be viewed as a tipping point. With every tick higher in the broad indices, likely on balance a few extra investors / managers / institutions are looking to take some profits off the table.
Months and years of gains accumulate, and more and more people are looking around asking when will this end? The longer the markets trek higher, the closer we get to that tipping point. When we reach a point where sellers are in control, a correction can materialize.
There are other reasons as well. HFT and technical analysis, tax loss selling, asset rotation, there are many reasons why markets correct. Like I said it’s completely healthy and normal to see small corrections within the context of a bull market. We’ve gone a very long time without even a 3% pullback, so one has to expect that several of the above reasons are in play for potential catalysts.
At the end of the day we won’t know until it happens, so we keep our head down and trade the math.
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