The first warning sign is that valuations and equity exposure are at stretched levels. In fact, the S&P 500 has gotten so overvalued that Howard Marks recently pointed out that J.P. Morgan research reveals that whenever the S&P 500 has reached its current valuation level, the next decade has always yielded real annualized total returns of around 0%. Additionally, there are numerous other metrics that indicate the S&P 500 is significantly overvalued right now.
Not only that, but the positioning of market participants is also indicating a very bullish, if not complacent, market sentiment. For example, household allocation to equities has reached near-record levels, and this has typically indicated that the market is late in a bull-run cycle. This makes sense simply because, from a mechanical perspective, the more people in the market, the greater the number that could be pulling out, or at the very least withdrawing their positions relative to new entrants and new additions being made. Not only that, but margin debt is at elevated levels. This typically indicates that investors are feeling too optimistic about the market and, should sentiment turn, could lead to an outsized downturn as investors flee to safety by closing margin positions, leading to outsized selling.
The third warning sign is an inverted yield curve. This is an important indicator because, while an inverted yield curve does not mean that a recession is guaranteed to happen, historically, yield curve inversion has been a very reliable indicator of an upcoming economic recession, as the chart below illustrates.
Given that the yield curve recently inverted quite sharply, that means that we may well be in store for a recession. This is because yield curve inversion tends to signal that monetary policy is too tight and, therefore, credit creation slows. This, in turn, can lead to both a stock market correction and a contracting economic environment. It also signals a risk-off environment because it means that investors are fleeing to longer-term bonds (TLT), which are traditionally a safe haven, as a way of hedging against a sharp economic downturn.
Sure, there is a bullish case for the market today, namely that we are on the cusp of an AI productivity boom as well as a manufacturing renaissance in the United States, both of which, if successful, could lead to enormous gains in economic activity, and where manufacturing-related job increases could help to offset some of the lost jobs due to AI. Additionally, the one big beautiful bill act from last year implemented tax and regulation changes that are overwhelmingly pro-business in nature.
However, as these indicators show, there is a strong case to be made for a sharp stock market correction, whether it be due to a recession, as the recent inversion of the yield curve seems to point to, or simply due to the fact that markets are overvalued and overleveraged. At the very least, with valuations and leverage at the levels they are at, any sort of speed bump, the AI boom, and/or material disappointment in economic activity in the United States could send markets substantially lower.
