Why a 10% Correction May Be Crucial to Keep Stocks Rising

U.S. equity markets have been surging upwards after plunging into negative territory at the end of last year. But the recent comeback looks set for a pullback. Several analysts are calling for a significant correction as the S&P 500 has climbed more than 18% since hitting late December lows. “Consolidation, a pullback is absolutely necessary,” Jefferies equity strategist Steven DeSanctis told MarketWatch, as he cited several factors that could trigger a correction, including slowdowns in major economies, profit declines and rich valuations.

“Anytime you see a big spike up, that’s generally met with a downtick. A 5% to 10% correction would be welcome and it would be justified,” DeSanctis continued. National Securities’ Art Hogan agrees, telling CNBC in a recent interview, “If you look back to the December low and the 18 percent pop we’ve had since then, … it makes sense to have a week or two of consolidation.”

Catalysts for a Market Correction

• Economic slowdown in U.S., China, or Europe
• Lowered earnings estimates
• Earnings declines
• Rich valuations
• Weak U.S.–China Trade Deal

Source: Jefferies, National Securities

What It Means for Investors

The recent surge in equity markets is largely a result of good news. Reports of progress on trade talks and the reversal of the Federal Reserve’s stance towards a more dovish one are helping to boost investor confidence despite emerging signs of slower economic growth in the world’s largest economies, including China, Europe, and the U.S. The growth slowdowns, however, are major reasons to remain cautious and why analysts are sceptical that the recent equity rally will continue its unrelenting climb.

If the trade talks between the U.S. and China go sour or a resolution looks like it may take longer than expected, then a pullback is likely, according to Hogan. From a technical analysis perspective, equities may pullback from merely hitting previous resistance levels. Signs that economic growth is picking up again may be needed before stocks push beyond those prior levels.

Along with lower earnings estimates and profit declines, DeSanctis believes that another potential catalyst triggering a pullback is valuations. According to The Wall Street Journal, S&P 500 stocks are trading around 20.2 times forward earnings. That’s slightly higher than they were trading in August and well above the 16 times forward earnings at the end of 2018. DeSanctis believes that a dip to around 17 times would make stocks look a lot more attractive than at their current level.

Looking Ahead

Even these warnings of an imminent market correction, however, could be overly optimistic. Slower economic growth, declining earnings, rich valuations, and delays in or deterioration of trade talks could send markets beyond correction territory and into free fall.