Next Stock Market Correction: Thoughts On Timing And Size

Includes: DIA, IWM, QQQ, SPY
by: Aloha Insight

History doesn’t repeat itself but it often rhymes. It holds for the stock market moves too.

The development during Great moderation suggests a correction is still some time ahead, and it should be relatively mild.

While the cyclical view is rather optimistic, the opposite holds in case of possible negative shocks.

History doesn't repeat itself but it often rhymes. By far the most important "verse" on the stock markets now is Fed's policy normalization and the first rate hike. Currently, it seems it could take place in September. What will happen before and after this move? The first of the following two charts shows a long term development of average hourly earnings, unemployment and Fed funds rate. We can distinguish two periods - first one is the Volcker's fight with inflation (largely irrelevant for current situation), and the second one is Great moderation. During great moderation, tree full cycles took place - three times the unemployment rate decreased to, or below 5 %, and three times the average earnings growth reached 4 % or more. We can call it a tight labor market.

We can also see that during great moderation, the Fed started with the rate hikes approximately one to two years before the point of maximum tightness of the labor market was reached. Actually, when it was reached, a turn of monetary policy towards easing already took place (and relatively soon after a recession started). This is a fairly standard cycle and if we add stock market to this picture, we see following:

During the first cycle, the stock market rose when the rates went up, and the market briefly corrected when labor market reached maximum tension, monetary easing started and the economy went to a recession. During the second cycle, the bubble burst. But it happened after series of rate hikes and only after the labor market got tight again. During the third cycle, the pattern was very similar again. The stocks moved sideways and then even rose after the rates moved up. And again, the market collapse came only after Fed started to ease and labor market become closer to overheating.

Therefore, the described pattern is rather clear: Fed hikes, labor market reacts with a lag, when it turns, the economy is already close to the recession and Fed switches to easing. This is the point, when the stocks correct, or even collapse. Mark Twain was right about the rhyming history and therefore I believe, the pattern will not repeat itself, but it will rhyme. How and when?

If we focus on the current situation, we see the unemployment rate is almost approaching the „critical" level marked by the previous cycles. On the other hand, average earnings growth is very far from the 4 % level, which coincides with previous turns. Fed has not started with tightening and from this perspective it actually does not really matter if the first hike takes place in September or few months later. There should still be rather long period (i.e., 1 - 2 years) before a correction takes place. Or will it be a collapse?

Again, using the rhymes of the history, I believe a corrections is more likely. Forward PE reached 25.5 and 15.2 at previous two peaks of S&P 500. Then it declined to 14.1 and 10.3, respectively. Today, the valuation stands close to 16.6, which is not low, but it is difficult to call it a bubble. In the first case (PE 25.5), there was clearly a bubble on the stock market (at least in the retrospect). In the second case (PE 15.2), there was a subprime bubble. I know that number of investors and economists believe we have a huge bubble in the bond market now, but I do not share this opinion (see for instance my previous posts focusing on Secular stagnation). Therefore, I believe there is quite a good chance this time the market move will rhyme more with the development at the beginning of the 1990s.

The above probably sounds quite optimistic (at least for those, who came to terms with the fact that corrections are recurring events). Nevertheless, should other than cyclical forces come into play (e.g., possible, but for some time still unlikely, strong shock from China, or chaos in the eurozone), we are in trouble. Reason is simple: There is limited room for both fiscal and monetary stimulation (although the room is to a large extent defined by our willingness to fight current economic wars and stop fighting wars that are long over).

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.