Is a Full-Blown Stock Market Correction on the Horizon?

It’s been an amazing year for stocks. But that’s all relative. On March 23, 2020, the stock markets bottomed, hammered by fears of the coronavirus.

It was a short-lived stock market crash. From the peak to trough, it took just 33 trading days for the S&P 500 to plunge 34%.

By August, the stock market had erased all of those stock market losses, with the S&P 500 and Nasdaq notching up new record highs since then. The S&P 500 has rallied 82% since then and is at record levels while the Nasdaq has more than doubled.

But there are growing concerns that the stock market rally could be coming to an end. Should stocks continue to rally, it is thought that any gains could be limited. And those gains won’t be based on fundamentals.

Could the Stock Market Rally Come to an End in 2021?

First, the stock market has largely priced in fundamental growth projections over the next 12 months to 18 months. The World Trade Organization raised its economic growth projections for 2021 to eight percent—the largest increase since 2010.Some Wall Street pundits believe earnings growth will surge 25% this year.

Again, those frothy projections are all relative. In a normal year, those numbers would be phenomenal. But 2021 is not your average year.

Keep in mind, the stock market cratered in 2020 and the global economy tumbled into a recession. You’d expect year-over-year estimates to be bullish when the economy is expected to recover after an abysmal year.

For the stock market rally to continue, something else will be needed to fuel it. If there isn’t, the rally could fizzle out and we could experience a full-blown stock market correction. This isn’t a doom and gloom prediction; stock market corrections, which are defined as a decline of at least 10%, are not uncommon.

Since 1980, the S&P 500 has experienced 38 stock market corrections; that works out to one every 1.87 years. Admittedly, the stock market doesn’t follow this number precisely, but in the current economic environment, a near-term stock market correction it’s not out of the question.

Other economic indicators are pointing to a stock market correction too. The Nasdaq has been in correction territory twice since February. Every time the Nasdaq has fallen between 12% and 14% over the last 40 years, the S&P 500 experiences a material pullback. If the Nasdaq correction becomes more pronounced, in excess of 15%, the S&P 500 has always fallen more than 10%. Should the Nasdaq continue to move lower, it would be bad news not just for tech stocks, but the broader stock market.

The Case Shiller S&P 500 price-to-earnings (P/E) ratio is another indicator that is pointing to a full-blown stock market correction. The most popular measure of stock market valuations, the Case Shiller P/E Ratio currently stands at 35.8. Over the last 150 years, the average is 16.80. This suggest stocks are overvalued by approximately 130%. The index has only been higher once; in December 1999, during the dotcom heyday. Where was the index on Black Tuesday in 1929—at 30.

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