The pre-correction risks:
- Based on historical PE ratio comparisons, the stock market was possibly overvalued. For example, the frequently referenced 10-Year CAPE ratio showed the extreme valuation at over 30 multiple, comparable only to the 2000 peak. Even the 12-month forward PE ratio was seriously elevated based on historical measures.
- Technically, the stock market charts went parabolic in January of 2018, with the monthly return of 7-8% for January alone.
Thus, the stock market was clearly in need of a "health correction", as it was unreasonable to expect the parabolic trend to continue, given the seriously extended valuations.
The correction trigger
The initial selling in February of 2018 was triggered by the expectations of a more aggressive Fed, given the rising inflationary fears. Specifically,
- The wage growth for January showed a 2.8% annual growth, which was higher than expected.
- The yields on 10Y Treasury Bonds, which were in a strong uptrend, approached the 3% level, and thus supported the rising inflation fears. Additionally, the rising bond yields challenged the stock market valuations based on the Fed model.
The initial sell-off
Low volatility was one of the key characteristics of the stock market uptrend since November of 2016, as measured by the VIX Index. As a result, shorting the VIX futures was one of the most popular trades during this period, or short volatility via ETFs. The initial sell-off caused the spike in the VIX Index, which caused the unwind of the short volatility trade. As a result, the blow-up in several volatility products such as (XIV) also caused the forced selling of stock market futures, and essentially caused the sharp 10% stock market correction.
The initial rebound
As the forced selling due to the unwind of the short volatility trade subsided, the stock market bounced from the 200-day moving average towards the previous highs. The inflation fears also subsided as the new inflation data came mild, and the long term rates moderated. Technology stocks even reached the new all-time highs.
The second sell-off
The second sell-off towards the 10% correction lows was triggered by the protectionist sentiment as the US proposed the steel and aluminium tariffs. The continued sell-off was supported by:
- The fear of trade wars, particularly between China and US.
- The sell-off of technology stocks, particularly the FAANG group.
Is the worst over?
So, let's address the risk associated with the correction:
- The valuation concern: Currently the 12-month forward PE ratio is around 17 times, which is slightly higher that the historical average of around 15-16, and thus does not indicate that the stock is overvalued. Stock are not cheap, but fundamentally, the valuation alone is not a reason to sell.
- Technical pattern: Technically, the parabolic uptrend is replaced with the double bottom 10% correction, which is a reason to be bullish.
- Inflation fears: It is still possible to get a "hot" inflation data point, given the anticipated economic growth and nearly full employment. However, the market is aware at this point that there is a "symmetrical inflation target" and thus, the stock market might not negatively react to slightly higher inflation numbers. Similarly, the stock market might also tolerate slightly rising long term interest rates, even above the 3% level. The stock market does not react equally to the same data-point twice.
- Trade war fears: The tariff proposals are just that - proposals. There is a period of about 2 months of discussions and negotiations on proposed tariffs, and in all likelihood, there will be a mutually beneficial agreement between the US and China on trade issues. The shock of initial tariff proposals is behind us.
- Technology sell-off: The sell-off in technology stocks is not a systematic event at this point - it should not affect other sectors of asset classes, or the fundamentals. We expect that technology stocks will start reflecting more systematic fundamentals, and less firm-specific issues.
Thus, it is likely that the worst is over for the stock market, at least from the news-flow point of view.
What to expect going forward?
As the US mid-term elections approach, we can expect a more positive news-flow. First, the stock market will likely re-focus on strong economic fundamentals, and strong corporate earnings growth. Second, the White House will likely refocus on infrastructure spending and other economy-friendly policies. Thus, it is likely that the US stocks will reach the new all time highs by the US midterm elections, which makes the current correction a buying opportunity.
Naturally, the risk factors are, as always, related to black swans events, or the low probability events. In this case, possible black swans are related to geopolitical events.
Longer term, the major risk factor for the stock market is related to the projected US budget deficits, potential rise in interest rates and the re-emergence of stagflation. However, these are risks for the 2019/2020, which should not be ignored, but also which are not likely to influence the markets in 2018.
Disclosure: I am/we are long S&P500. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.