Stock Market Correction Typically Happens in the Fall When Markets Are Overextended; Special Considerations This Year
Whether you’ve been sitting out equities in fear of lofty valuations, looking to lock in gains, or perhaps even thinking about shorting the market, investors are wondering when the next stock market correction will come. A meaningful correction hasn’t taken place for so long that the melt-up almost seems “normal.”
There’s nothing normal about today’s zombified market environment from a historical perspective. It’s all about central bank liquidity, which makes this rally different from any other. Free market economics do not exist anymore. When that party ends, so will the rally.
And according to the Federal Reserve, monetary tightening is coming in September 2017. The Fed is expected to begin reducing its $4.5-trillion balance sheet to about $2.0 trillion sometime in 2022. Initially, $10.0 billion will be draining out each month as the Fed declines to reinvest the proceeds of its maturing holdings of U.S. Treasury bonds and mortgage-backed securities. By the end of 2018, it could be $50.0 billion/month. But the key thing for investors to know is that liquidity is being sucked out of the system, and that’s bad new for the stock market. There’s no historical precedent with a balance sheet tapering of this size. (Source: “Watch Out for Popping Bubbles,” U.S. News, July 28, 2017.)
As Quantitative Easing (QE) was largely responsible for the biggest stock market rally in history (despite growth that never broke stall-speed), Quantitative Tightening (QT) might have the same, strong opposite effect. Yes, some dumb retail money still flows into passive exchange-traded funds (ETFs). But that’s not enough to maintain these valuations without banks reinvesting bond proceeds back into the market.
Institutional money is what really moves markets. Now that the Fed is ending that game (if not until the next financial crisis), how do historic valuations hold without strong growth? This business cycle—which is the third-longest in history—has already peaked. Strong growth after the U.S. Housing Bubble never came, and it’s guaranteed not to come now. Growth is at, or slightly above, the rate of inflation. That’s not growth, that’s treading water.
If concerns about Fed asset purchase tapering wasn’t worrisome enough, there’s also the upcoming U.S. debt ceiling crisis. It has the potential to trigger a coming stock market correction. Why? Because if the debt ceiling isn’t raised by sometime near the end of October 2017, the U.S. could default on its obligations. Without the government’s ability to issue more Treasury securities, America will have to prioritize bill payments, since more money goes out than comes in (otherwise known as running a deficit). This will create chaos in the capital markets. Think uncertainty, a crashing U.S. dollar, and risk of a credit downgrade. The latter is the linchpin of a strong U.S. dollar.
As we can see from the chart below, U.S. sovereign risk is at the highest levels since Lehman Brothers Holdings, Inc. collapsed. This is indicative of the growing debt ceiling limit concerns; specifically, the possibility that the Trump administration may not be able to broker a budget deal that raises the limit.
Would anybody be shocked if Trump opponents used the debt ceiling crisis as a way of sabotaging Trump’s presidency? When you think about it, it provides adversaries a powerful opportunity. Trump could be blamed as the president who brought chaos to America. The economy would capitulate, and many needed government programs would be frozen.
Even if the blame really lies with Congress, the populace are growing weary with the lack of action in Washington. Rightly or wrongly, Trump would take the fall. A chaotic debt ceiling deadline miss would provide cannon fodder to those who want to see him ousted. If Russia couldn’t do it, perhaps a domestic crisis could.
Diving deeper into speculative fervor, if a large U.S. stock market correction 2017 resulting from debt crisis materialized, it would provide a perfect opportunity for Wall Street to take profits and capitalize from plummeting prices on the short side. It would also provide an ideal “washout” scenario, in which optimism and dumb money are swept away. The market is in desperate need of this.
These potential outcomes are speculation on my part, but are possibilities nonetheless. The chart above tells the whole story. If investors didn’t fear a debt ceiling debacle, why are sovereign risk spreads so high? After all, inflation is contained, unemployment is low, markets are soaring and the Volatility Index (VIX) is trading at all-time lows. Sovereign risk shouldn’t be soaring…unless there’s an event on the near horizon promising to upset the apple cart.
Expect a 15%-25% Percent Market Correction in the Final Quarter of 2017?
Very few investors expect the scenario in the title to play out. And why would they? The last correction of any significance came during the Brexit vote (June 2016), and even then, the S&P barely fell five percent peak-to-trough. If you blinked, you missed it.
Admittedly, few stock market correction indicators are signaling at the moment. That’s a reflection of the non-stop bull run we’ve seen in equities. But nothing lasts forever. Market sentiment can change on a dime if the right set of conditions come along. One such condition is a clear indication that America is headed for recession (however, I don’t expect that until 2H 2018 at the earliest). The other is brinkmanship over the coming U.S. debt ceiling crisis (as mentioned above).
The reason why the latter has such market-moving ability goes beyond the credit markets shock a default would deliver. It would undeniably signal that Donald Trump is powerless to push through bipartisan infighting. Probability of Trump’s tax initiatives would be discounted to zero. Political instability and tension would soar, as “impeachment” talk would gain steam. And higher interest rates would force debt servicing costs much higher for Joe Public, thus torpedoing the economy. Especially in combination with a U.S. credit downgrade (something that already happened in 2011), the debt ceiling crisis has the potential to push recession risk forward. Needless to say, crashing earnings and historic valuations don’t mix.
In short, there is lots of heavy-duty risk coming up in the markets this fall. Not just equities, but bonds and currencies as well. Unlike past years, where a debt ceiling raise was a given, half the political spectrum is dedicated to eliminating Trump. It remains to be seen whether they would use this potential crisis for their own ends.