When is The Next Market Correction?
Market corrections are a very common occurrence in financial markets. But what is a “correction”? A market correction is defined as a decline of 10% or more in the price of a security (stocks, bonds, etc.) from its most recent peak. Corrections can be either brief or last days, weeks, months, or even longer. For as long as investors have been trading securities, there have been times where the prices disconnect from their underlying value. Excessive valuations can be attributed to many factors, some of which include new government policies, emerging technology, or low interest rates. Regardless of the root cause, corrections are bound to happen. The better question is how can we predict when these corrections will occur?
It is impossible to predict an exact date, however there are indicators we can key on that one may be approaching. One of which is the P/E ratio for the S&P 500, a ratio commonly used to find out whether prices are overvalued or undervalued relative to earnings. The historic average of the S&P 500 is around 17, whereas the current P/E ratio, as of April 2021, is estimated to be about 42, indicating a potential overvaluation of the market as a whole.
Another market currently heating up is Real Estate. An indicator used to determine corrections in real estate is the price to rent ratio. Housing prices have surged partly due to shortages caused by government policies such as eviction moratoriums and mortgage forbearance, with areas like Atlanta seeing prices rise over 120% since 2012, in contrast to rental prices which have only seen a gain of 55% over the same time period. With over 2.7 million U.S. homeowners still taking part in forbearance plans, as of mid-January, a cause of concern for owners who will not be able to support their mortgage if they have to rent out their property.
Beyond numerical indicators, speculations on certain conditions may set the stage for a correction. One of these conditions is the record breaking amount of government issued stimulus, which has led to an abundant amount of private sector investors looking for new places to park their extra cash. Instances of this can be seen during the recent Dogecoin, NFTs and GameStop pumps. An increased tightening can occur once the excess money dries up. A similar market which may see issues is “Clean Energy” particularly after the fall of the Electric Battery trade and potential effects of President Biden’s Green Energy Bill. Green infrastructure has seen a high degree of investor confidence in recent months due to this administration’s climate and sustainability agenda. However it takes years before this type of infrastructure is actually built. Before U.S. elections, alternative energy stocks outperformed traditional energy stocks by a very wide margin, roughly 100% (indicated in the chart below.) Capacity and shortage of materials, spikes in commodities (lumber up 232%, gold up 20%, silver up 47% since March 2020), and concentration into a few green companies, can lead this sector into correction territory.
In the past, strong investor sentiment towards a specific sector has led to sharp decreases in price which can happen quickly e.g. tech companies in the late 90s or real estate in the mid to late 2000’s. Market corrections are difficult to pinpoint in real time, but understanding that they are a normal occurrence and knowing what to look for is important for investors to make better decisions when the time arises. Corrections are like a spider under your bed. You know it's there, lurking, but don't know when it might make its next appearance.
Sources: The New York Times, Charles Schwab, Investopedia, Fortune
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