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Is the SA stock market heading for a correction?

Are we naïve for wanting to believe in fairy tales? Surely no one would rather believe in the worst possible outcome? Mankind is inclined to believe that all things will turn out for the best, but does this belief system apply to investments as well? When looking at a graph depicting the last 50 years’ movements on the JSE/All Share Index, the answer is, absolutely. The general trend is upwards and corrections are usually relatively short-lived.  

Before I continue, however, I think we should just briefly discuss the definition of a correction. Although there is no concrete definition for a market correction, among stockbrokers it means a 10% or greater decline from the market’s peak levels. In today’s terms, that would mean a decline to levels of around 48 150 and lower from its current levels of around 54 000 (at the time of writing on 16 May). This may seem like an inconceivable drop, but the reality is that the FTSE/JSE All Share Index has experienced at least 11 corrections of 10% or more since January 2000. 

It may sound like a lot, but it isn’t all that strange an occurrence. Everyone refers to the last three years’ movement on the stock market as sideways, but many do not realise that we have experienced two corrections of 10% or more in the last 24 months alone. We remained optimistic, however, and quickly eliminated short-term losses by rapidly moving back to previous highs.  

But as important as it is not to be driven by pessimism when it comes to investing in shares, investors should also be cautious not to be overly optimistic. Always remember the following two important factors when considering an investment in shares:  

First, you should always have realistic expectations; and second, remember that the South African stock market is but a small fish in a vast ocean. To illustrate this, let’s use the largest share/company in the world, called Apple. Like many other companies following recent trading, Apple reached new heights, and at a current market capitalisation of $777bn, it is almost 2.5 times the size of the current South African annual GDP.  

When looking at the vast ocean as a whole, I think it’s clear that optimism is currently a very powerful driving force behind the market. In my column of 30 March 2017 (The dangers of simply following the herd), I explained how too much optimism managed to force the volatility index (VIX) of the Chicago Board Options Exchange (CBOE) very close to those dreaded 10% levels. I also mentioned that every time that percentage fell to below 10%, it was seen as one of the greatest buy indicators in history. With many not realising it, that percentage fell to below 10% a few times in the second week of May, prompting the question: where to now? 

No different to the SA market (trading above a price-to-earnings ratio [P/E] of 20 times), the S&P 500 is currently trading at a P/E of 25 times versus its historical average of 16 times. Surely it can’t be healthy to assume that they will just keep on reaching new heights? I agree that it’s nothing new that we are now trading at more expensive levels, but what worries me is that 81% (according to a recent Bank of America Merrill Lynch survey) of fund managers in the US currently feel that stock markets are trading at levels that are too expensive.  

That doesn’t mean that we are nearing the end, however. Joseph Fahmy, managing director of Zor Capital, recently released a report in which he compared the movements of the S&P 500 between the corrections of 1987 and 2009. Although the reasons for the two corrections vary greatly from each other, it was quite interesting to see that the two graphs look almost exactly the same. If history should repeat itself, a final run in the stock market may be more likely to happen before we see the next correction.  

No one knows if this time will really be different. John Templeton once said the four most dangerous words in investing are “this time it’s different”.

Schalk Louw is a portfolio manager at PSG Wealth.

This article originally appeared in the 25 May edition of finweekBuy and download the magazine here.

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