Why U.S. Stocks Are About to See a Correction

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The U.S. stock market is beginning to look seriously overstretched. But while adding to one’s position isn’t without risk, a pullback could very well create an opportunity for investors.

Monday, the three major U.S. stock indexes began down considerably, before climbing modestly by mid-afternoon. Stocks sold off on Friday, as fears of increased military tensions with Iran took center stage. Investors fear that a war or conflict could emerge and that such an event could likely involve the U.S.’ destruction of Iran’s oil supplies infrastructure of the closing of the Strait of Hormuz, bringing the price of oil higher, but profit margins for U.S. companies that buy oil lower.

Many on Wall Street either don’t expect a full conflict to develop or, if it does, don’t see it as a material negative to stocks. As for oil, the expected added supply from large producers around the globe should outweigh a drop in supply due to a U.S. - Iran military conflict. A depressed price of oil would dispel the secondary market fear that higher oil prices would put cost pressure on companies that buy oil for operations.

Still, near-term fears centering on the Iran issue could act as the catalyst for a stock market correction that some think is slightly overdue.

“The duration of the extreme overbought condition coupled with the excessive optimism represent cloud buildups that should be avoided,” said Canaccord Genuity’s Chief Market Strategist Tony Dwyer in a note. “The developing conflict with Iran may act as a catalyst for the market to finally see a correction, but if it weren’t the Iran issue it would have been something else.”

First off, the average multiple of next year’s earnings on the S&P 500 is 18.8, against the last 10 year's average of below 16. While economic data has trended positively of late, most on Wall Street still view the economy as “late cycle." U.S. stocks experienced a broad-based rally in 2019,bringing the S&P 500’s gain for the year to 27%. Some said the last leg of the rally -- a Santa Claus rally -- was attributable to investors funding 401K’s for year-end and portfolio managers wanting to show their investors a substantial position in equities. Investors’ cash on hand has also been high in the last few years, serving as an enabler to those slightly bullish.

But a correction, Dwyer says, would be just that — a correction. He doesn’t forecast a bear market any time soon and neither do most strategists. Dwyer notes two particular points of optimism.

1.Credit spreads are thin. The spread between riskier U.S. high yield corporate bonds and the safer 10-year treasury bond is at a low for the current economic cycle, at around 3 percentage points. That compares with a spread of roughly 4 or 5 percentage points for most of the current expansion dating back to 2009. A tight spread shows investors are paying a high price for high yield bonds, indicating they see corporate credit as sturdy.

2.Economic fundamentals are strong. This does’t mean the economy isn’t late in its cycle, but unemployment is still below 4% and GDP growth remains around 2%. Many expect a GDP deceleration in 2020 to close to 1%.

Case in point: While Dwyer said "We have continued to advocate holding off on adding exposure into the strength over recent weeks,” the expected dip "can create tactical opportunity."