The stock market is in an interesting place, following a ten-month advance to new highs. However, there's some reasons to believe that a correction is near.
How We Got Here
To recap, the bull market that began in March persisted despite real and continued weakness in the economy due to the coronavirus. However, there was also abundant amounts of fiscal and monetary stimulus which made up for a lot of the lost economic activity. Now, with the population slowly getting vaccinated, the intermediate-term outlook has certainly brightened as it seems the world could return to normal by Q2-Q3 of this year.
Clearly, stocks are more connected to this instead of the near-term outlook which continues to get worse. This week, we had 1 million jobless claims reported. Additionally, case counts and coronavirus deaths continue to trend higher. There is also at least one to two more months of bad weather which seems to correlate with rising cases as well.
Yet, this has been bullish in some ways for stock prices as it indicates more stimulus. By many measures, investors' optimism has been justified. The depressed parts of the economy - services, travel, restaurants, etc. - will become positive contributors once the population gets vaccinated. Other parts of the economy such as tech, housing, and manufacturing are in expansion mode. Other positives include strong household balance sheets, massive amounts of incoming fiscal stimulus, and zero-percent interest rates until 2022/2023.
Time for a Correction
All of these positives are resulting in higher interest rates. Higher interest rates can be bearish for certain parts of the market such as growth stocks, dividends, and fixed income. In addition to these factors, other sectors - manufacturing, consumer discretionary, and "reopening" stocks - have reached overbought levels.
Some sort of correction that allows these overbought sectors to correct, while interest-rate sensitive sectors see deeper pullbacks seems likely. Recent history also shows that there tends to be a big correction in Q1 during years that follow major market advances such as 2010, 2014, and 2018.
A big chunk of the market's gains is due to retail investors dominating the market. We see record-levels of bullishness in terms of sentiment and measures like call buying which correlate to market crashes rather than continued gains. Some other bearish factors are the number of special purpose acquisition companies (SPAC) and initial public offerings (IPO). New supply is also bearish for the markets as some holdings need to be sold. Last week, we also saw extraordinary gains in many stocks with high short-interest like GameStop
Therefore, investors should take a defensive stance, focus on protecting profits, and manage risk more aggressively.
