A correction coming?

I've been a market bull for some time and believe the underlying fundamentals are strong. But I'm also a pragmatist. It's 'that time of the year' when we have seen some of the worst market downturns.

Moreover, I was struck in recent times by the volume of people concerned about preparing for any possible correction. At a recent Eureka Report webcast I was surprised by how many attendees wanted more information on the risks – both historical and actual – of a correction as our market finally breaks into higher ground and starts looking at 6000 points.

What is a correction, and how many have there been?

While there is no precise definition, it’s generally agreed that a correction is a fall in stock prices of 10% or so within a reasonably short period of time (days/weeks). This contrasts with a pull-back which is a decline around 3-5% or a bear market where the market may fall 20% or more over a longer period of time – months or years.

Chart 1: Four corrections since the GFC

Chart 1 shows that since the GFC, the All Ordinaries has experienced four solid corrections, although some may call the period up to mid-2011 a bear phase as stocks fell about 20%. Either way, the last correction we had was May to June 2013, although we’ve had a couple of decent pull backs since then – most notably the 6.7% fall late 2013 and the 5% pullback earlier this year.

Now corrections generally don’t happen just because. In each of those four corrections we’ve seen in this rally so far, all of them had quite serious catalysts. In 2010 and 2011 we had the European debt crisis. In 2013 we saw  the so called ‘taper tantrum’ whereby markets sold off on indications the US Federal Reserve was planning to step back from quantitative easing. With that in mind, it’s reasonable to assume that in order to see another correction, we’re going to need to see something and something big.

What are the most likely candidates?

The absence of any major economic imbalance domestically or abroad (that is a housing glut, investment glut or some real economic excess that requires an adjustment) implies to me that the real economy is unlikely to be the source of any upcoming correction. Consequently, earnings should remain robust – the US economy is surging, Europe is doing what Europe always does (i.e. not much) and elsewhere things are going OK. World growth should be around trend. It’s a similar story for Australia – not too hot and not too cold.

Having said that, and in the Australian context, there certainly is scope for the so called ‘capex cliff’ to cause a correction on the All Ords if markets panic. (A capex cliff is where a sudden slowdown in capital investment would traumatise the wider economy).

Now I have to stress that the actual drop off in mining investment isn’t a big deal in a macro economic sense. It only represents 6% of the economy and 1-2% of the labour market. Not all mining investment is going to cease as well, it should be noted. However, if investment should drop off suddenly, then it is possible we could see the bulk of that decline in investment over a few quarters. If we do see that then headline GDP would look very weak - even if the remaining 94% of the economy is posting above trend growth. Markets could see that and panic, regardless of what the underlying economy is doing. A correction could ensue and I’d have to put this is a decent probability.

Another candidate is that if the Fed and the Bank of England do actually tighten rates. Both central banks have flagged for quite some time that rates could go higher, possibly earlier than markets expect. Unfortunately both banks have also been very inconsistent in delivering that message – policy makers seemingly have changed their minds month-to month and even week-to-week. It’s this haphazard communication that could cause a problem if and when they do actually tighten rates. But the bottom line is that if central banks are lifting rates, then things are obviously looking very good indeed. Any selloff would probably be short-lived then.

Of course, wider geopolitical tensions are a constant risk and, to be honest, they would have to be very high on the list right now. Conflict in the Middle East, Europe … who knows, maybe even Asia the way things are going. The foreign policies of some of our key allies are such a mess now in so many places – really anything could happen. At this point though markets are not alarmed, and nor should they be.

What are the other possible sources?

Less likely are some of the usual suspects that we frequently read about. Unlikely, of course, but not impossible.

For instance, if Chinese growth falters our market will most certainly correct. The chances of this are low, however, and I’m not of the view that the initial market reaction would be sustained. The truth is, even in a recession, such as in 2009, Chinese growth was strong. More to the point, if needed and desired, Chinese authorities have plenty of policy ammunition to throw at the economy if they choose. So I think a downturn or hard-landing is a low-probability event.

Even less likely than that, though on the radar, is a European bank disaster. The European Central Bank is currently conducting stress tests on 120 European banks to determine how sound they are. I remain confident that those results will be positive and most analysts agree that the worst is now behind us. Markets may disagree, however, and we’ll have to wait for the results.

The other main risk stems from central banks. Specifically, the possibility that we may see destabilising capital flows from ECB-Fed divergence. Similarly it’s unlikely, though possible, that central banks, including the RBA, may end up tightening too aggressively.

Is there anything in the price action?

Where the All Ords sits on the charts (via technical indicators) depends very much on what time period you want to look at and what indicator. Noting this, the main thing that stands out for me (in chart 2 below) is that the Aussie market has decisively broken out of the range it had held since late 2009. The uptrend was established in early to mid-2012, and the market is currently at the mid-point of an ascending channel. That’s not really a strong signal that a correction is looming. I mean let’s face it, the Aussie market has been a slow moving beast and I don’t think a strong argument could be made that it has run up too hard (based just on the price action).

Chart 2: Price action is benign

Overall I think the prospects of a near-term market correction are low. The economic backdrop is simply too benign and policy makers stand prepared to pump up the market in the event of any adverse scenario anyway. In addition, the market itself doesn’t appear to be overvalued with one-year forward price-earnings ratios at around 14 to 15. That isn’t terribly threatening and price action hasn’t been particularly aggressive – especially compared to US markets. Corrections do happen though, and the above represent the most likely sources of any market angst.