Is a stock market correction coming?

Jeffrey Knight, CFA, Global Head of Investment Solutions and Asset Allocation | December 16, 2013

  • Why we are not expecting a major correction
  • The case for ongoing equity market strength
  • Factors that might bring on a correction

With markets near all-time highs and the potential for the Federal Reserve to begin tapering asset purchases, many investors are asking if the next market correction is coming and if it’s time to sell stocks. While we can never know for sure when a correction is coming, at this time we do not expect a large correction.

Why not?

As intuitive as it may seem that recent performance has been too good to last, and that we must be “due” for a correction, history simply does not support that view. First, we have seen the U.S. equity market repeatedly make all-time highs during 2013. The following analysis shows that such repeated breaches into record highs tend to be followed by another strong year. As of December 5, 2013 there have been 44 new highs posted by the Dow Jones Industrial Average (DJIA) year-to-date.

DJIA gains in years with records and in following years (1904 – 2012)

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Source: Ned Davis Research, as of December 5, 2013

If we look at this another way, the strongest percentage gain years typically suggest ongoing strength as well.

Best annual S&P 500 returns since 1947 and subsequent year’s return

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Source: RBC Capital Markets, Haver Analytics, Standard & Poor’s. Past performance does not guarantee future results. Diversification does not assure a profit or protect against loss.

The Columbia Global Asset Allocation Team’s recent research work suggests ongoing strength in equities too. The team’s proprietary U.S. equity “scorecard” currently stands at its second (2 out of 5) most bullish mode. In addition, other analysis focused on the business cycle indicates ongoing expansion of the U.S. economy, which also argues for ongoing equity market strength.

What might bring a correction?

1) Recession. Interestingly, in the absence of recession, the stock market tends to perform fairly well. Neither Marie Schofield (our chief economist) nor Zach Pandl (our chief interest rate strategist) assigns a material probability to recession in the United States next year.

2) Financial accident. Of course, you can never know for sure, but we believe this is not likely in the age of financial sector deleveraging, Dodd Frank, etc. In addition, we are not currently observing speculative leverage to the degree consistent with a major blow-up, nor do we see the types of unusual financial market patterns that are often revealed before a significant financial accident.

3) Policy mistake. Ahh, here we might have a case. Tapering is the obvious candidate, particularly since it appears that a tangible impact of Quantitative Easing has been in elevating stock prices. Even so, prices are not outrageously high today, at least not high enough to signal an imminent correction or a likely negative return over a strategic horizon of several years.

To conclude, we don’t think it is time to sell stocks. While our active asset allocation indicators remain favorable for the time being, we constantly monitor developments in momentum, sentiment, macroeconomic conditions and valuation for guidance. Should a correction materialize over the near term, we would still consider adding to equity allocations during periods of elevated volatility.