Macroeconomics and politics
5 min read 15 Jan 25
Since the end of the correction in October 2022, the stock markets have been in a highly dynamic bull market, which is reflected in double-digit gains in many stock indices over the last two years. From the perspective of a euro-based investor, the MSCI AC World Index is up 49% over the last two years, while the S&P 500 Index is up as much as 63% (each including dividends). The DAX also gained an impressive 43% during this period despite the economic slowdown. We believe these returns are well above what equity investors would expect in the long term. This raises the legitimate question of whether such a period of rapidly rising stock prices could potentially be followed by a more pronounced correction.
Past performance is not a guide for future performance
In fact, with the increase of stock prices, valuations have also risen significantly. This means that the price increases were not driven exclusively by higher corporate earnings. A significant part of it is due to an increase in P/E multiples. For example, the P/E ratio of the S&P 500 was 18 in October 2022, but has since then climbed to 29 (as of 31 December 2024) – an increase of 50 %. A similar development can be observed in the German equity market, albeit at a lower level.
Even if high valuations alone are usually not a reason for a correction or a bear market, they can at least influence the extent of the fall. A simple calculation illustrates this: the median average P/E ratio of the S&P 500 over the last ten years was 23. This means that, assuming flat earnings, the S&P 500 could theoretically correct by 21% before reaching its ten-year average. Taking into account an expected earnings growth of 7%, which is roughly in line with the long-term average, the theoretical correction potential by year-end would still be around 15%. Note that in this case, the index would be neither particularly expensive nor particularly cheap from a historical perspective. Even without any nasty surprises – such as a recession in the US – a correction of 15% would therefore not be completely unusual.
However, major corrections are usually triggered by market psychology factors. In this context, the average expectations of market participants and market sentiment play a crucial role. Negative news does not necessarily have to lead to falling stock prices if market sentiment and the expectations of market participants are pessimistic. A rise in the stock prices despite pessimistic sentiment may even indicate further price potential. As the saying goes ‘the market is climbing a wall of worry’. However, if market expectations are too optimistic and market sentiment is too complacent, even slightly negative surprises can be enough to trigger a correction. A good example of this is the correction in 2022, when the technology sector and growth stocks – and here in particular the unprofitable ones – came under extreme pressure, putting an end to the speculative excesses of the previous months.
The fact that many major stock markets are close to their all-time highs suggests that there is little indication for pronounced pessimism at the moment. Looking at the US equity market, however, the almost exuberant optimism that followed the election of Donald Trump as the new US president seems to have started to falter. And this despite – or perhaps because of – the strong US economic data that has been reported recently. Due to the robust data, market participants have significantly scaled back their expectations for further interest rate cuts by the US Fed. The result has been a rapid rise in long-term US Treasury yields, which in turn is now challenging the stretched valuations of many US stocks – according to the broad interpretation of market participants. If stock prices suddenly start to fall on positive news in a market phase with positive sentiment, this could be a sign of overly optimistic expectations. In that case, it might be better to buckle up.
From a technical perspective, the US stock market has been in a consolidation phase since December (as of 10 January 2025), which could well lead to a correction. However, a bear market (losses well over 20%) would likely require factors in addition to a turnaround in sentiment, such as an unexpectedly sharp recession (there is very little evidence of this in the US at the moment) or a drastic escalation in global trade relations (cannot be ruled out, but is rather unlikely in terms of severity).
One risk factor to watch, particularly with regard to the US equity market, is the rapid rise in long-dated Treasury yields. Should US inflation suddenly pick up again in the course of the year (not our base case scenario, but not out of the question either), this could be accompanied by a further rise in yields along the yield curve, which could put stock market valuations and thus stock prices under further pressure. In my view, rising bond yields could therefore prove to be the most likely trigger for a long overdue correction in US equity markets at the moment.
The value of the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. The views expressed in this document should not be taken as a recommendation, advice or forecast.