Investment Bank Pins 3-Month Stock Market Correction Odds at Even Money
Citigroup Inc (NYSE:C) has joined the chorus of mainstream investment banks raising concern about the current rally. They forecast a greater-than-45% likelihood of an impending stock market correction, with odds on the upswing. If you’ve recently staked a large position in the market, this can’t be comfortable news.
While the S&P 500 made yet another record high midweek, it wasn’t the only noteworthy news. The market rise on September 13, 2017, also solidified the current bull market as the third-strongest ever. Aggregate percentage gains are now 269% bigger than the generational lows seen in 2009. (Source: “One Bank Calculates The Odds Of A Market Correction In The Next 3 Months,” Zero Hedge, September 14, 2017.)
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Put in context, it may seem like the great bull market from 2009-on is no big deal. After all, it only moved into third position. So perhaps more upside is ahead? Perhaps.
But this business cycle rally is much more impressive when you consider the starting point of the S&P 500 before the rally started. It was obviously much higher than in 1932 and 1990—the starting points where generational gains were higher than the present period. In fact, the S&P 500 was only around 9.50 at the start of 1932 and 353 in 1990.
Where am I going with this? Simple arithmetic states that it’s easier to obtain more impressive growth rates starting from a smaller base. Growing from 10 units to 100 units is simpler than growing from 100 units to 1000 units. It’s the reason why large companies generally have slower growth rates than smaller companies—growing from smaller base integers is easier.
So while the S&P 500 is “only” third in generational bull market percentage increases, the rally could be the strongest in history already.
Many in the industry have taken notice. The surprising thing is the ease in which the market has dismissed mainstream investment banks’ predictions of market turmoil. Usually, when Wall Street investment banks agree with contrarian money managers, something’s up. Citigroup rarely ever agrees with the likes of Peter Schiff or Bill Fleckenstein.
Yet, the market rages on.
Is There a Market Correction on the Horizon?
Wall Street analysts like giving odds. They place odds on things like the Brexit outcome, chances of the next recession, chances of a rate hike at the next Fed meeting… Investment banks are paid to forecast the likelihood of future events to safeguard and grow client money. It’s what they do.
But curiously, when it comes to stock market correction predictions, they rarely give odds. They usually resort to vague warnings that the market could “correct” without placing any actual odds on it.
Whether that’s indicative of buy-side bias, or not wanting to be responsible for large outflow selling of client money, we’re not sure. But actual stock market downturn odds seem to lag where predictive odds of other economic events are readily available.
That is, until now.
According to Citi’s research, the odds of a stock market correction are greater than 45% within three months. Their analysis is based on a couple factors: frothy valuations and waning earnings growth.
Unlike other economic indications, these metrics don’t lie. There’s ample lagging economics data telling us the market is great: low unemployment, soaring small business optimism and decent consumer price index readings (not too hot, not too cold). But this data isn’t forward-looking, and is practically useless as a predictive indicator.
Valuation metrics, on the other hand, are different. There’s a reason why valuations are tightly correlated with long-term returns, and it has nothing to do with luck. Citi’s data corroborates and synchronizes harmoniously with other more famous valuation metrics like the CAPE ratio.
That’s an acronym for Cyclically Adjusted Price/Earnings ratio. It’s probably the most cited valuation metric on the planet. It measures stock market “expensiveness” by comparing prices against a 10-year earnings average and adjusts for inflation. It’s effective because it smooths out chaotic earnings volatility and adjusts for the gradual debasement of money over time.
Right now CAPE is reading 30.7, the second-highest figure ever. Little more commentary needs to be added. The market is simply the second-most expensive ever, based on the most trusted valuation metric available. Citi’s own findings are just an extension of that.
As for earnings growth, there’s little evidence that’s ramping up anytime soon. Certainly nowhere near enough to justify such valuation expansions.
S&P 500 Earnings Per Share Forward Estimate
| June 30, 2017 | 27.00 |
| March 31, 2017 | 27.46 |
| Dec. 31, 2016 | 28.87 |
| Sept. 30, 2016 | 26.59 |
| June 30, 2016 | 25.69 |
| March 31, 2016 | 24.10 |
As we can see, going back to Q1 2016, earnings growth is at the midpoint up until last quarter. The last two quarters have seen actual declines. If earnings growth hasn’t taken off yet, it’s not happening this business cycle. We may see markets edge up for another year or two, but earnings will get hammered next recession. They always do.
But until the next recession occurs, Citi is banking on a stock market forecast for the next three months. The high odds and short time frame strike us as quite bearish, coming from a mainstream investment bank. The must trust their data to make such a bold proclamation.
Citi is quick to add that most market corrections are associated with a trigger…but in hindsight. In other words, one day, the market will crash and nobody will know why until months later. That’s hardly reassuring to investors—especially recent ones with little cushion to buffer losses against.
Of course, there’s no shortage of bearish catalysts to slay the bull: North Korea, Chinese trade war, China credit bubble bursting, de-dollarization of international trade. The list goes on.
Is a stock market correction coming? Nobody knows for sure. But what we do know is that odds are increasing. Citi is no doubt betting the time is now for something to trigger. Investors really need to ask themselves whether grinding out a few more percentage point gains is worth the risk.
