The Vanguard Group, the mutual fund and ETF giant with about $4.5 trillion under management, warns that the U.S. stock market is long overdue for a correction of 10% or more, and gives a probability of 70% that one will occur in the near future, CNBC reports. Vanguard is a longtime proponent of long-term investing, and issues this warning with the intent of having clients prepare, rather than to frighten them into hastily dumping their equity holdings, CNBC notes. "Having a 10% negative return in the U.S. market in a calendar year has happened 40% of the time since 1960," says Joseph H. Davis, global chief economist at Vanguard, per CNBC. (For more, see also: Is a Stock Market Correction Ahead?)
The commonly-accepted definition of a correction is a decline of 10% or more in the stock market, but with no particular timeframe attached. It may be a short, sharp decline, or a long, slow one. Given that the S&P 500 Index (SPX) has risen by nearly 17% for the year-to-date through Tuesday's open, a 10% correction between then and year-end still would leave the index up by about 5% for 2017. Once a market decline reaches 20% or more, that normally denotes a bear market, especially if the retreat extends over many months, or perhaps years.
Signs of Froth
Several indicators monitored by Davis suggest that the market has signs of "froth," or excessive optimism and bullishness, according to CNBC. In particular, he notes that risk premiums are low by historic standards, and continue to shrink. These include the narrow yield spreads between bonds of varying credit quality. They also include the flattening yield curve, the product of narrowing yield spreads between bonds of varying terms to maturity. High valuations on stocks, as indicated by high price/earnings (P/E) ratios or their inverse, low earnings yields, are another indicator.
Vanguard Chief Economist on Stocks & Fixed Income
Vanguard already has been warning clients for much of this year that the bull market has pushed stock valuations to such a high level that they should have diminished expectations for future gains. In its annual economic and investment outlook document published last week, Vanguard expects that the total return from U.S. stocks will be only about 4% to 6% annually during the next five years, its lowest projections since the start of the recovery after the financial crisis, CNBC says.
Vanguard founder Jack Bogle, meanwhile, is at the low end of that range, anticipating 4% average annual returns on U.S. stocks in the future, per a recent interview with CNBC. Nonetheless, Bogle still sees U.S. stocks as the best long-run investment option, per CNBC. (For more, see also: Vanguard's Bogle Favors US Stocks After 400% Gain.)
No Market Top in Sight
Meanwhile, two established indicators of market tops are absent right now, according to Bob Pisani of CNBC, their stocks correspondent since 1997. The first is when stocks that are advancing in price start to be outnumbered by those that are declining. This has not happened yet, Pisani says. The second is when the main impetus for stock trading shifts from buying by bulls to selling by bears, putting downward pressure on prices as supply outstrips demand. He doesn't see that either, right now.
By contrast, Pisani says that the advance/decline line for the NYSE is at a historic high. Meanwhile, a small increase in selling pressure a few weeks ago was insignificant and short-lived, he adds. Given that a negative signal from the advance/decline analysis normally precedes a market top by four to six months, Pisani expects that the bulls have room to run.