2018 could be a rude awakening for investors who haven’t set stop limits for their equities, as research conducted by Vanguard Group ($5 trillion) sees a 70% chance of a US stock market correction, a 30% increase over what has been the norm for the past 60 years.
Last week, Vanguard published its annual economic and investing outlook, advising investors to expect between 4% and 6% returns from stocks in the next five years.
“Having a 10% negative return in the US market in a calendar year [within a five-year forward period] has happened 40% of the time since 1960. That goes with the territory of being a stock investor,” Joe Davis, the firm’s chief economist, told CNBC. “It’s unreasonable to expect rates of returns, which exceeded our own bullish forecast from 2010, to continue.”
According to Davis, the continued compression of risk premium is one of the indicators for the imminent correction, which Vanguard expects to experience a 60% drop when international equities are included in a stock portfolio.
“It doesn’t drive risk down to zero, but valuations are not neatly as stretched in other parts of the world,” Davis said. “The real power is other developed markets.”
Another indicator for the correction is the growing concern for a flattening in the yield curve. While the two-year and 10-year note yields are at the lowest levels since before the financial crisis, the spread between junk bond yields and Treasurys are closer to the level before the crash than the long-term historical average, as reported by CNBC.
Strategists at Morgan Stanley ($1.3 trillion) forecast the end of the current bull market to happen within the first half of 2018 due to new flows from retail investors, following the signing of the tax bill.
“We expect volatility to finally pick up in a more sustained manner as growth decelerates and financial conditions tighten,” the strategists wrote. “We would be very surprised if we don’t return to a more normal environment and witness at least one if not several 10%-plus drawdowns next year.”
Although the strategists are not expecting a 2018 recession, they are predicting the stock market could start discounting a possible recession in 2019.
“On that note, credit markets may be topping now, which tends to be a good 6-12 month leading indicator for stocks,” they wrote.