Is the Stock Market About to Correct?

Early in August, the NASDAQ experienced a 10% drop in response to a much weaker-than-expected jobs report.

Though the market has since made up the ground it lost as hopes of a new rate cut from the Federal Reserve bolstered stocks, the question of whether a more lasting correction is on the way remains quite relevant to investors.

Is the stock market about to correct, and what options exist for investors to manage a market downturn?

What Could Bring About a Stock Market Correction?

The most obvious catalyst for a stock market correction would be a macroeconomic downturn. Analysts at J.P. Morgan analysts currently foresee a 35% chance of a recession beginning by the end of 2024 and a 45% chance of one beginning by the end of 2025.

Excessively high stock valuations could also set the stage for a general selloff. By most metrics, stocks are about as expensive today as they were before the stock market crashed in early 2022.

Warren Buffett’s favorite market indicator, the ratio between the total capitalization of the US stock market and GDP, moved above 2.0 earlier this year. This suggests that US equities are significantly overvalued, creating the conditions for a selloff if any sort of obstacle arises to continued economic growth.

Closely related to the potential for a selloff due to overly high valuations is the chance that the market could correct as investors price in more moderate growth from AI technology.

A year and a half after the rollout of ChatGPT, Wall Street is increasingly re-evaluating generative AI’s ability to produce higher earnings.

While large tech companies keep investing in infrastructure, cutting-edge chips and more efficient models, AI’s uses so far have been quite limited. If the market prices in either lower earnings growth from AI or a longer time frame for that growth, many stocks are likely to retreat to lower levels.

Finally, seasonality may play a role in the near-term fortunes of the stock market. Historically, September has been the worst month for US stocks over the last century.

Although there is no direct causal explanation for this so-called September Effect and it may be nothing more than an anomaly, it has been persistent enough in US economic history to be worthy of note.

Given that the market already appears to be uncomfortable with current stock prices and wary of any macroeconomic headwinds, it’s entirely possible that September could be a rough month for stocks once again.

What Options Do Investors Have if the Market Drops?

If history is any guide, one of the best options in the event of a stock market correction may simply be to hold large indices like the S&P 500.

Over the past 30 years, the S&P has produced an average annualized return of about 9.7%. This 30-year period included the dot-com bubble, the 2008 financial crisis and the 2020-21 era, all of which caused stocks to sink dramatically.

Nevertheless, the long-term trend has remained markedly positive. This suggests that holding an index of high-quality stocks and continuing to dollar-cost average into it may be the best long-term solution to the problem of periodic market downturns.

A downturn could also be an opportunity for value investors to find attractively priced individual stocks to add to their portfolios. Buying the dip in undervalued companies can be a good way to set a portfolio up for strong long-term returns.

Investors must carefully evaluate individual stocks during downturns, though, as it can be difficult to determine which companies are truly undervalued and which are trading lower because their fundamentals have changed.

Blue-chip dividend stocks are also a common shelter for cautious investors during hard times. Even though the prices of these shares may sink during market downturns, their reliable quarterly payouts offer investors a fairly predictable stream of cash flow and help to improve overall returns.

Industries such as utilities, consumer staples and value retail are thought to be particularly good holdings for recessions, as these areas of the economy are fairly recession-resistant.

Investors who are focused on preserving their existing capital may also find bonds attractive. Even though the Federal Reserve is expected to begin moderately cutting interest rates later this year, 10-year US treasuries are still yielding about 3.8%.

This yield is well below the historical average returns of the US stock market but still above the current inflation rate of 2.9%. As such, bonds may be a safe option for investors close to retirement who are more concerned with security than ongoing growth.

For investors who are willing to look beyond stocks and bonds, real estate can also be a decent choice for generating returns when stocks move lower. Real estate offers a relatively low correlation to the stock market and the ability to produce reliable income through rent.

Because the Federal Reserve often lowers interest rates when the economy is growing slowly, buying real estate can become more affordable when the broader economic outlook isn’t particularly positive.

With average annual returns of about 4-8% depending on the period, real estate also offers decent opportunities for price appreciation.

Is the Stock Market About to Correct?

While it’s impossible to say whether the stock market is due for an imminent correction, there are several factors that may cause one.

High share prices, a deflation of AI hype or a slowdown in the macroeconomic landscape all have the potential to trigger a selloff. It’s important to acknowledge, however, that none of these outcomes is a certainty and stocks may also continue to move higher in spite of what appear to be meaningful headwinds.

On average, bull markets last just under four years. The current bull run began in late 2022, meaning that it would be a short one by historical standards if it ends this year.

Even if a new bear market does begin, though, prudent investing strategies and diversification may be able to help investors ride out the storm.

Attempts to time the market are famously prone to failure and often result in losses, but owning high-quality stocks, indices or bonds over long periods of time has historically been a reliable method for generating returns in both good times and bad times.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.