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Is a Stock Market Correction in the Cards?

Charles Lewis Sizemore, CFA, Contributing Writer, Kiplinger.com
Historically high stock valuations and murky economic data point to a mean reversion. Here's how to prepare for whenever the ax falls.

The Standard & Poor's 500-stock index rocketed more than 15% higher through mid-April. But it's telling that the lion's share of the gains came in the first two months. Stocks have moved higher since the start of March, but at a much more leisurely pace with several stops in between.

Is this merely a pause en route to further gains, allowing investors to digest the strong start to the year? Or could something else be afoot?

Could it be that the bounce in January and February was merely a short respite in the downtrend that started late last year, and that another stock market correction could be on the way - as soon as this quarter?

Naturally, there is no way to know with 100% accuracy until after the fact. But there are plenty of reasons to be concerned that the rest of 2019 might not be as enjoyable as its first quarter. Let's look at those reasons - and discuss a few tweaks you might want to make to your portfolio.

Stocks Aren't Cheap

Let's start with valuations.

In the immediate future, valuations really don't matter. Expensive stocks can get even more expensive, and cheap stocks can get even cheaper.

SEE ALSO: 10 of the Worst Stock Calls By the Pros

Benjamin Graham, the father of the investment management profession as we know it today, explained it succinctly. He said in the short-term, the market is a voting machine; in the long-term, it is a weighing machine.

In other words, short-term returns are purely a function of human emotions. But over longer time periods, valuations matter. So, it you're putting cash to work with a time horizon of years, the price you pay today matters. And today, stocks are expensive.

Today, the S&P 500 trades at a cyclically adjusted price-to-earnings ratio (CAPE) of 31.2. There are only two times in history that the CAPE has been materially higher: the 1920s market bubble and the 1990s market bubble - both of which preceded not just stock market corrections, but full-blown bear markets. According to research firm GuruFocus, today's valuation implies annualized compound losses of 1.6% per year over the next eight years.

It's not just the CAPE.

"Stocks are expensive by virtually any metric you want to use," says John del Vecchio, noted short seller and co-manager of the AdvisorShares Ranger Equity Bear ETF (HDGE). "The price-to-sales ratio for the S&P 500 is higher today than during the 1990s dot-com mania. Price-to-book ratio, dividend yield, Tobin's Q ... Pick any of these broad market metrics, and they'll tell you the same story. Stocks are priced to deliver lousy returns over the next decade."

The Economic Picture Is Murky

Perhaps expensive stocks could be justified if we were on the cusp of a period of sharply higher economic growth and profits. But considering that, at 10% of GDP, corporate profits are already near all-time highs, it seems unlikely that capital's slice of GDP would grow much from here.

Already, political winds seem to be shifting, with politicians harping on the fact that median American wages have barely kept up with inflation in recent decades. It's hard to imagine the next decade of legislation being as favorable to American business as the past few decades.

The American consumer is also looking a little wobbly. January retail sales came in stronger than expected with growth of 0.2%. But this followed a truly disastrous December in which retail sales declined 1.6%, marking the worst month in nine years. And retail sales followed up that January bump with a 0.2% decline in February.

SEE ALSO: 17 Retailers at Risk of Defaulting or Going Bankrupt

Worse, the slowdown comes at a time when the consumer is overleveraged. Auto loan delinquencies recently hit new all-time highs, and overall consumer debt has risen for 18 consecutive quarters.

The housing market is also sending some worrisome signals. As Lance Gaitan, editor of Treasury Profits Accelerator, recently wrote:

December home sales were expected to drop back below the 600,000 annual rate, but instead jumped to 621,000 - climbing by 3.4%.

That was the good news.

The bad news was November's stellar 657,000 figure was revised down to 599,000. On top of that, October was revised another 13,000 units lower.

Since then, February new-home sales improved by 5%, but that comes after a January in which they declined 6.9%.

And we have yet to see what sort of impact a slowing China may have on the global economy.

As of this writing, there was no evidence that a recession was imminent. But at least a few quarters of relatively sluggish growth seems likely. The Atlanta Fed's GDPNow estimator pegs first-quarter GDP growth at just 2.3%.

The Kiplinger Letter is forecasting slower annual GDP growth for the next two years - from 2018's 2.9% down to 2.5% in 2019 and 1.8% in 2020.

Reversion to the Mean

Various studies have shown U.S. stocks to rise at a compound annual growth rate of about 10% per year. But this assumes a longtime horizon of 20 to 30 years. Over shorter horizons, stock returns can be wildly higher or significantly lower - even negative.

Consider that from 1968 to 1982, the S&P 500 went nowhere, giving investor price returns of zero (though investors did collect dividends during that period). The same happened between 1996 and 2009, and worse, yields were much lower during this period than during the 1968-to-1982 stretch. Suffice it to say that these years saw returns much lower than the long-term average.

But that's the nature of mean reversion. Long stretches of subpar returns are followed by long stretches of higher-than-average returns. Since bottoming out in 2009, the S&P 500 has compounded at 15.4% per year, which is much higher than the long-term average.

Unfortunately, when you consider this as well as today's high valuations, it likely means we're due for another long period of underperformance.

What You Should Do

Now, a mean-reversion model like this should be viewed as a broadsword, not a surgical scalpel. It's not going to tell you the precise day, month or even year that you should pull the ripcord and get out of the market. So while a stock market correction certainly is possible sometime this quarter, it's far from a foregone conclusion - a significant pullback could be much further out.

SEE ALSO: 12 Dividend Stocks That May Be Income Traps

Nor is any of this to say you should sell everything and run for the hills.

Given the long-term success of buy-and-hold strategies over the course of American history, most investors should have at least have some exposure to the stock market more or less permanently. An investment in the market via a broad vehicle like an S&P 500 index fund or ETF, such as the SPDR S&P 500 Trust ETF (SPY), is essentially a long-term bet on America. And as none other than the legendary Warren Buffett has repeatedly emphasized, betting against America is generally a bad idea.

But there are times when a little extra caution is warranted and when it might make sense to hold a little more cash than usual. When you see relatively limited upside in the immediate future, that's the prudent move.

"Never forget that cash is a position too," writes J.C. Parets, founder of technical analysis research firm All Star Charts. "Don't let anyone tell you that heavy cash positions are a bad idea. It's your cash. You earned it. If you want to raise cash during more volatile environments, I think it's way better than getting chopped up, or worse, closing your eyes and hoping the big bad market goes away."

If you're looking to earn a little extra interest while still maintaining maximum liquidity, consider keeping some of your cash in T-bills or short-term bonds. If you prefer ETFs instead of individual securities, consider the SPDR Bloomberg Barclays 1-3 Month T-Bill ETF (BIL) or the iShares 1-3 Year Treasury Bond ETF (SHY), both of which yield around 2.3% at current prices.

SEE ALSO: The 45 Cheapest Index Funds in the ETF Universe

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