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What will cause the next correction?

Jan 5, 2014 @ 12:01 am

By Ed Mccarthy

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The U.S. equity markets had a good run in 2013. Despite worries about Fed tapering and higher interest rates, Washington's dysfunctional behavior and a modest economic recovery, the S&P 500 rose 29.6% for the year.

As markets moved higher, however, investors speculated when the next correction would arrive and what would cause it. Advisers, meanwhile, took another serious look into active investment strategies to prep for any potential market shifts in 2014.

InvestmentNews asked several economists, investment strategists and investment advisers for their insights. And while they agreed that black-swan events could hit the markets hard, they said there is no evidence of sector-specific price bubbles or an overheating IPO market that could cause a pullback. They believed instead that fundamentals — economic weakness, earnings that fail to meet projections, or Fed miscues — were much more likely to set back the bull market.

GROWING OR STALLING?

The U.S. economy continues to recover from the financial crisis, albeit at a modest pace. According to the Department of Commerce's Bureau of Economic Analysis, gross domestic product grew by 2.5% in 2010, 1.8% in 2011 and 2.8% in 2012. On Dec. 20, the Commerce Department revised up its estimate for the third quarter of 2013 to a robust 4.1% annual rate. But the outlook for next year is less clear: In early December, Standard & Poor's lowered its 2014 GDP growth forecast to 2.6%, from 3.1%.

John Canally, an economist with LPL Financial, believes investors assume that the U.S. is in the middle of an economic cycle. But if the economy actually is closer to the end of the cycle, that realization could cause a correction, he said.

“If we don't get a re-acceleration in growth now that all the government uncertainty is out of the way, I think that might cause a market correction, because people have largely marked up their growth estimates — not only in the U.S. but globally — for next year,” he said.

Mr. Canally follows multiple indicators to gauge the economy, and LPL combines several of those indicators to create its proprietary Current Conditions Index. That index reached a new high in early December, which the firm said “suggests improving economic conditions in the United States.”

Nonetheless, there are significant pockets of weakness in the economy. Lee Partridge, chief investment officer of Salient Partners, cited the potential impact on retail sales of the still-high level of unemployment in the U.S. The Bureau of Labor Statistic's U-6 measure, which accounts for temporary workers and the underemployed, was 13.2% in November.

Overall, unemployment has proved difficult to reduce. Mr. Partridge pointed out: “Labor force participation has declined since 2009 by exactly the same percentage that the unemployment rate has been reduced. If you look at labor force participation, that's fallen by 3.2%; the unemployment rate has come down 3.2%.”

This employment weakness means that median-income families are “really, really stretched right now,” Mr. Partridge said. Consequently, holiday sales outcomes for retailers such as Wal-Mart, Target and J.C. Penney will hinge on their buying power. If sales figures are weak, it could trigger a negative shift in market sentiment.

EARNINGS AND VALUATIONS

Another potential risk for the equity markets is high expectations for corporate earnings in 2014 and beyond. According to S&P Capital IQ's survey of Wall Street economists, as of November, the 2014 consensus earnings estimate was $121.24 per share, versus a projected $110 per share for 2013. In its Nov. 1 Lookout Report, S&P Capital IQ questioned whether U.S. and global economic growth will be strong enough to achieve the $121 forecast.

Brad McMillan, chief investment officer at Commonwealth Financial Network, is skeptical that earnings growth can meet projections. He's observed a pattern in recent quarters' results: Expectations initially are set high and subsequently adjusted lower, making it easier to beat those reduced expectations. In response, the market has continued to move higher as investors have kept shifting their growth expectations into the future.

But that pattern can't continue indefinitely, and Mr. McMillan suspects investors' attitudes could change early this year. “I think we're really getting to the point where there isn't too much else we can do to meet those expectations,” he said. “The gap is going to come when the market starts to realize, no, we're not actually going to see that kind of earnings growth going forward.”

Mr. Partridge believes an increase in the costs of raw materials, labor or interest expense could be a threat to profit margins. If those margins slip, current valuations might prove unsustainable.

Valuations have crept up from about 14 times earnings on the S&P 500 to about 17, Mr. Partridge said. But “there really hasn't been this huge increase in the bottom line. It's really been more a function of valuations continuing to expand in the wake of really high profit margins.”

THE FED

The Fed announced Dec. 18 it would cut back its $85 billion-per-month Treasury bond and mortgage purchases to $75 billion, starting this month. It will wind down and ultimately cease purchases this year, as long as economic indicators stay on track. Just as important to the markets, the Fed also plans to keep short-term interest rates near zero as long as unemployment stays relatively high and inflation low.

The taper's economic impact could manifest itself in several ways, said Russ Koesterich, chief investment strategist with BlackRock Inc. If mortgage rates move sharply higher, that could undermine housing activity. Another possibility: higher rates on lower-risk fixed-income assets could entice investors away from the riskier assets — such as high-yield bonds and stocks — that they were forced into because of the low- interest-rate environment.

The fact that everyone knows when the taper is coming doesn't eliminate the uncertainty of its outcome.

“With the Fed finally commencing its long-awaited taper, investor attention is likely to revert back to market fundamentals,” Mr. Koesterich added in an e-mail after the Fed's decision. “For stocks, the big question is whether a stronger economy will translate into stronger earnings growth.”

Of course, the markets could work through any uncertainties along the taper route — and continue higher. Chris Cordaro, chief investment officer at RegentAtlantic Capital, points to two previous extended bull markets as historical evidence of the market's staying power. From August 1984 through October 1997 (39 months) and from February 1991 to October 1997 (81 months), stocks moved continuously higher without a 10% or greater decline.

“Even though we've had a very robust 2013, there's not a mandate that we get a decline,” he said.

Ed McCarthy is a certified financial planner and freelance financial writer in Pascoag, R.I.

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