A sharemarket correction appears to be likely but trying to time a reversal is pointless

Sharemarkets face increasing headwinds thanks to sticky inflation and hi-tech valuations but a long-term investor should be able to take it in their stride.

The vexed question of how to prepare for a market correction need not be traumatic.

The chorus of investors who believe the market is due for a correction is growing louder, and the list of reasons is growing longer.

I have some sympathy with the view the market could pull back. I believe there is an ever-present risk of such pullbacks, so if one should emerge, it would not be surprising. Additionally, I have no belief in anyone’s ability to forecast the precise timing of such a pullback consistently, so now could be as good a time as any.

One argument put forward as a reason to expect a pullback is that many stocks have risen a lot.

Goodman Group, for example has risen more than 60 per cent in the past year. Megaport has risen by more than 250 per cent in that time. Even the ASX 200 is up 14.4 per cent from its October lows.

Does that mean stocks are now going to fall? If only predicting the zigs and zags were that easy!

I find this argument difficult to accept as a reason to expect a pullback because it only recognises a rise in price and fails to acknowledge the level from where that rise came. Were the shares bargain-priced before they took off, or were they already expensive? The same argument also fails to answer whether the shares have now become expensive on either a relative or absolute basis. Some insights into past or current valuations need to be provided. Even then, prices can remain reflective of exuberance for a long time.

Another argument is that ­prices for many companies have raced ahead of revenue and earnings growth. This appears to be true, for example, for companies exposed to the general adoption of artificial intelligence.

US Federal Reserve chairman Jerome Powell. Picture: AFP

If the benefits (revenue and profits) take time to flow through, shareholders may grow impatient, in which case their subsequent selling would prove current prices were unjustifiably high.

Much of this argument, however, depends on some assumptions about valuations, which are a reflection of popularity and sentiment, and what they might do next. If, for example, earnings have grown 10 per cent over the past year and are expected to grow another 10 per cent next year, then provided the price-earnings ratio remains the same (the popularity of stocks doesn’t change), one could reasonably expect prices to rise by 10 per cent this year and 10 per cent next year. But we don’t know whether stocks will become more or less popular over the next year.

If stock prices reflect optimism about rate cuts and continuing disinflation, and those events fail to transpire, or they take longer than desired to do so, there is a risk the popularity of stocks could change, PE ratios would contract and, even if earnings grow by my hypothetical 10 per cent, share prices won’t.

But how can we predict a change in sentiment?

US 10-year bond yields have been testing levels last seen in ­November. At 4.5 per cent, they are meaningfully higher than in December, when they hit 3.75 per cent. But before jumping at another shadow, keep in mind that 10-year yields have been rising, as has the stockmarket, in defiance of the usual negative correlation.

I am reminded of the regularly trotted out issue of US debt. Like the recently rising bond yield in the US, that country’s debt has also been rising, and many have suggested the debt will catalyse a calamitous sell-off in equities.

According to the St Louis Fed, US federal debt was $US327bn in 1970 and today it stands at $US34 trillion ($53 trillion). Over 53 years, that’s an average annual growth of 9.2 per cent, and it has never experienced a year of decline. Despite this, the S&P 500 total return index has risen about 10.59 per cent a year, according to officialdata.org. What gives?

The debt may yet trigger a correction, but one must ask why it hasn’t done so already.

Expectations of a correction in stocks are bound to mount the further the market rises, but unless you can predict when a change in outlook for the economy, rates or earnings will prompt a change in sentiment, predicting a correction is futile.

My solution? Have about half your wealth in high-quality equities, including some small caps, and have the rest in cash and high-yielding investments.

You can add to the equities when they are down, and take some profits when they have rallied strongly, using the bucket approach I have written about.

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management