- Historically, equity markets have averaged two corrections of at least 5% each year.
- The lack of corrections in 2017 is unusual, but not unprecedented.
- A significant correction in the fourth quarter is unlikely for reasons outlined below.
Historically, equity markets have averaged two corrections of at least 5% every year. There hasn’t been one yet this year, making 2017 unusual — though not unprecedented.
However, the lack of a correction so far in 2017 does not make one more likely in the fourth quarter. While the possibility of a correction cannot be ruled out, the accelerating rate of earnings growth and the strength of the macroeconomic environment make a significant correction unlikely anytime soon.
Over the last half century in the United States, economic recessions have inflicted harsh losses on equity markets, with an average 39% plunge. This dark cloud has a silver lining: Such losses are rare in the absence of an economic recession. And in today’s economic conditions, the risk of a recession is low.
Two effective indicators remain encouraging
The Leading Economic Indicators Index (LEI) and the yield curve have historically proven to be effective for forecasting economic recessions. Since 1956, the yield curve has inverted before every economic recession — 10 out of 10 times. As the fourth quarter begins, the yield curve is not inverted, and the difference between the two-year and 10-year yield, rather than being negative, is somewhat higher than it has been in many recent years.
The LEI also has a solid track record in signaling recessions. When it turns negative year over year, an economic recession generally follows in the next six to twelve months. Today, the index is not only positive, but actually accelerating year over year. This adds to my confidence that an economic recession is not in the foreseeable future.
While GDP growth is not robust, it is positive and has accelerated quarter over quarter this year. Inflation, meanwhile, remains in the 1%–2% range, a historically sweet spot for the equity markets. All told, economic conditions are not strong enough to spark an aggressive rate hike program by the Federal Reserve. As a result, companies are enjoying a favorable environment for earnings growth: The economy is expanding enough to lift revenues, low inflation restrains costs, and low interest rates keep borrowing attractive. As a result, earnings growth is forecasted to accelerate.
Given these conditions, it would be unprecedented for the U.S. economy to fall into economic recession and rare for a meaningful market correction to occur, when earnings are accelerating. A benign macro environment and accelerating earnings provide a bridge to support the market until early 2018. At that point, there is a reasonable likelihood that the Trump administration will have pushed pro-growth fiscal policies and lower taxes through Congress, providing potential new impetus to the market.
Weighing the risks
It is unusual to have an equities market that does not experience at least one 5%+ pullback in a calendar year. For that reason, a market correction in the short term would not be a surprise. However, market history suggests that the likelihood is low, and if one occurs, it might be shallow and brief. The conditions associated with sharper corrections are not in place. A benign macro environment, no signs of an impending U.S. economic recession, and accelerating earnings provide a favorable context.