From Context, the AllianceBernstein blog:
Many investors think US stocks are due for a correction: They feel that the market has run too far, that the Fed has been slow to act, that complacency has created pockets of excess. Do these gut feelings mean a major equity correction looms? Not yet, in our view.
The S&P 500 Index has seen 16 one-year corrections of at least 15% since 1927. These corrections were preceded by sharp equity run-ups, and we’ve seen a comparable return streak recently. This is consistent with the intuition that equity corrections follow on the heels of excessive optimism.
Common wisdom—colored by 2007—says corrections are preceded by complacency, but this doesn’t bear out historically. Trailing volatility and asset correlations in precrisis periods—the “price” of risk—are roughly in line with historical averages. Of course, even if complacency doesn’t seem to precede corrections, that doesn’t mean it should be ignored. The take-away is that cheap capital can boost asset prices much longer than appears rational. The key in today’s market is to monitor and hedge exposure to areas of excess that are forming in the markets because of abundant liquidity and cheap risk.
A Historical Perspective
Almost every economic recession since 1950 followed a flat or inverted yield curve, and most equity corrections have followed a flattening yield-curve slope. The current yield curve is still very steep in historical terms, but the recent flattening is consistent with fears that the Fed is slow to respond—and that the eventual withdrawal of liquidity will hurt economic growth. The big issue is timing: equity markets generally rally early in rate-hike cycles and decline only after interest-rate policy is viewed as hurting future growth. When rates rise from very low levels, equity returns are actually strongest (Display).
What about the most obvious indicators of an equity correction: earnings and valuations?
Surprisingly, earnings per share fell in just over half of the market corrections since 1950. This is at odds with many investors’ views, which are anchored in the last two corrections, 2000–2001 and 2008. Those corrections happened during recessions, and were extreme in the context of earnings declines at the time...MORE