The Investment Scientist

Is A Market Correction Finally Happening?

Posted on: October 25, 2018

150106094958-market-correction-1024x576.jpgAs of yesterday’s closing bell, the Nasdaq Composite is already in correction territory, down more than 12% from its high. However, the other two indices have yet to reach the correction stage, which is marked by a drop of at least 10%: the Dow is down 8.4% while the S&P 500 9.4%.

I am going to look at the recent market drop from two perspectives: statistical and economical.

Looking through the lens of statistics, a correction is long overdue. Why? Well, the historical odds of a correction are once every two years, those of a bear market once every five years. Yet the last time we had a correction was in 2011, seven years ago. Is it well-overdue?

Looking through the lens of economics, there are two exogenous economic forces that are influencing the market. One is the Trump tax cut, the other is the Trump trade war. These two forces are driving the market in opposite directions.

The tax cut primarily benefits US multinational corporations (MNCs). US MNCs originally had $1 trillion parked outside the country to avoid the old 35% corporate income tax rate. Trump cut the corporate income tax rate to 21%. On top of that, for foreign profit repatriation, the tax rate was cut to 10%. Since the tax cut was enacted last December, $300 billion has been repatriated, much of which was used for share buybacks. As corporations get to keep more profits and outstanding shares are reduced, overall earnings per share jump, thus pushing share prices higher.

The trade war, on the other hand, is a drag on the market. The steel and aluminum tariff is just a small piece, but it is already hurting US manufacturers that use these commodities. I am actually optimistic that most smaller countries will eventually capitulate. Larger countries and economic blocks like Japan and the EU will find compromise as well. The most intractable is with China.

For the year to date, China’s stock market is down 22%, the US’s is down about 2%. This has the adverse effect of making the Chinese less likely to come to the negotiation table since these numbers look bad on their face. Remember when their market was merely flat a few months back? They were much more eager to resolve the issue then they are now.

So what is my prognosis? Nobody can predict the market since it depends not only on the interplay of opposing economics forces but also on the perception, fear and greed of market participants. That said, I still believe a correction, even a bear market, is long overdue, and that means opportunity. Should a bear market happen, there will be a natural floor. This is because not only will corporations flush with tax cut cash could do more share buybacks, but both the Trump administration and the Chinese are more likely to get a trade deal done. The administration will not want the bear market to last and the Chinese will be able to save face.

(Feel free to share if you find it insightful.)

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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