As of the date of this writing, the S&P 500 is up 27% for the year, and the Dow Jones Industrial Average is up 23%. This year’s exceptional performance has been largely to an expansionary monetary environment created by the Federal Reserve and a recovering housing market, among other things. While most investors have benefited from remaining in the market this year despite significant domestic political turmoil and global instability, there is a strong case to be made for an upcoming market correction. (Note: a correction does not mean a crash.)
An appropriate starting point for such an analysis would be to look at current fundamental market valuations. One important measure is the S&P 500 Shiller P/E (price to earnings) 10 ratio. This ratio is based on current stock prices and the inflation-adjusted index earnings from the previous ten years. The historical mean of the Shiller P/E is 16.5, meaning that investors have been willing to “pay” $16.50 for every $1.00 of a company’s inflation-adjusted earnings, on average. Right now, the Shiller P/E 10 ratio is sitting just above 25.5, which is about 54% higher than the historical average. This means that investors are essentially paying more for stocks (when compared to earnings), than they have historically. As a reference, the S&P 500 Shiller P/E 10 ratio was in the mid 40s before the dot-com bubble burst, and was approaching 30 before the ’07-’08 financial crisis. While one ratio alone cannot depict a complete view of the market, this data does seem to provide evidence of a relatively overvalued equity market.
If stocks are currently overvalued, as some indicators suggest, what could potentially trigger a correction? There are several events coming up in early 2014 that could:
Affordable Care Act Provisions, January 1, 2014
Many key provisions of the Affordable Care Act go into effect on January 1st of next year. One of the more significant provisions is the “Individual Mandate”, which makes it a requirement for all Americans either purchase health insurance or pay a yearly penalty for being uninsured. The long term economic impact of the Individual Mandate is up for debate, and there is sure to be a lot of continued media attention on the ACA. The Employer Requirement has been postponed by the Treasury Department until January 2015, which will require certain employers to offer coverage to full time employees. This will likely have a stronger impact than the Individual Mandate. Stay tuned in 2015.
Sequester, January 15, 2014
As part of the government budget cuts that started in March 2013, even more cuts will go into effect in January 2014. Sequestration will reduce the yearly government budget by an additional $24 billion, on top of the approximately $80 billion reduction seen in 2013. While the effects of budget cuts in 2013 did not have as harmful results as expected, some experts believe the additional cuts in 2014 could have a greater effect than 2013’s cuts.
Debt Ceiling Expiration, February 7, 2014
This could potentially be the biggest driving factor for a market correction. The recent government shutdown and debt ceiling crisis only ended October 17th, but it appears that investors are quick to forget the significant underlying debt issues that our country faces. The short term extension of the deadline from October to February is just a way for Washington to delay dealing with the issue, and it has become almost routine. If the status quo continues, it is only a matter of time before U.S. debt is downgraded again. A market downturn is almost inevitable if a credit downgrade occurs. Having debt ceiling talks take center stage again in February could very easily result in increased uncertainty and volatility in the market.
It should be noted that corrections are a very normal part of the stock market, and should be expected. Unfortunately, not every year can be a 27% up year, as much as we would like that to be true. With current market valuations at elevated levels, plus upcoming political and economic events that could temporarily derail the upward progress we have seen throughout 2013, it is reasonable to expect a correction in our somewhat near future. Of course, attempting to “time the market” is generally a losing battle. In the very long term, the stock market will always go up. If a downturn does happen soon, it may provide investors with a valuable opportunity to add to their portfolios while stocks are on sale.