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October 10, 2017

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Is a Correction on the Horizon for US Stocks?

May 3, 2017

The S&P 500 index has enjoyed a strong run of late, shrugging off a multitude of concerns to rise approximately 15% in capital appreciation terms over the last year. As a result, after such a formidable run, it’s likely that many investors will be feeling positive about their investment portfolios at present.

 

However, when investing begins to feel ‘easy’, and market volatility is a distant memory, it’s often a signal that the market should be approached with caution. Indeed, the more complacent investors become, the more powerful the volatility can be when it returns to the market.

 

While market participants are most likely not yet in the ‘irrational exuberance’ phase of investing, as they were, for example, during the technology bubble of 1999, several indicators suggest that an element of caution might be appropriate in the present climate. With that in mind, here’s a look at three contrarian signals that suggest a market correction might not be far away.


Investor sentiment

 

The first indicator that suggests that caution towards the share market is warranted right now is investor sentiment. Sentiment is a classic contrarian indicator and when investors are in a feel-good mood, it often means it’s time to batten down the hatches. As Warren Buffett insists: “be fearful when others are greedy and greedy when others are fearful.”

 

At present, sentiment towards US stocks is very positive. For example, Bank of America’s Sell Side Indicator, which measures the bullishness of US stocks, recently hit a 20-month high, a level not seen since the oil price crisis in early 2015. This indicator is calculated using the average equity allocation recommended by Wall Street strategists at the end of each month and according to Bank of America, has been a reliable contrarian indicator in the past. In other words, when Wall Street analysts are overwhelmingly positive towards stocks, it’s time to tread carefully.

 

 

Volatility Index

 

Another key indicator worth monitoring is the CBOE Volatility Index (VIX), also known as the ‘fear index.’ The VIX is a popular measure of market volatility and is calculated on the prices of options on the S&P 500 index. The VIX spikes higher during market volatility and falls back during periods of calmness. For example, while a level of 15-20 is relatively normal for the VIX, during the Global Financial Crisis, the index spiked as high as 90.

 

The VIX has remained remarkably subdued over the last twelve months, despite events such as the US and French elections and the Brexit vote in the UK that could have derailed global markets. And just this week, the VIX has fallen below a level of 10, its lowest level in over a decade. This is an incredibly low level for the index, suggesting that markets are in a complacent, over-confident mood. And when fear is absent from the markets, it generally means volatility may be closer than many believe.

 

 

M&A activity

 

Lastly, it’s worth keeping an eye on merger and acquisition (M&A) activity because history has shown that many large M&A deals tend to occur just before market peaks. This happens for a variety of reasons, one being that mergers often make the most sense when a company’s organic growth opportunities are slowing. Mergers offer the opportunity to enhance both the top line and the bottom line, an attractive option if growth is diminishing.

 

There’s been some significant M&A activity in the last six months, including AT&T’s $85 billion bid for Time Warner, which if it goes through, will be the sixth-largest merger of all time. More recently, Kraft Heinz made an audacious $143 billion bid for rival Unilever, although this offer was quickly withdrawn.

 

Does this M&A activity confirm that we’re at a market peak right now? Not necessarily, but taken in conjunction with the sentiment and volatility indicators above, it suggests that an element of caution towards the share market might be sensible right now.

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