A bear market for stocks, in which prices drop by at least 20%, may be necessary to address six major challenges facing Wall Street right now, according to Jim Paulsen, the widely followed chief investment strategist of Leuthold Group. "The issues confronting stocks are numerous and most will likely remain periodically problematic for the balance of this expansion. Consequently, resolving 'problems aplenty' will not be easy. And, ultimately, it will be resolved by a bear market and a recession," says Paulsen per Business Insider. He says the six big problems include stretched valuations, a full-employment economy that's boosting wage costs and inflation, Fed rate hikes, the lowest intra-market correlation since the 1950s, historically low volatility despite recent spikes, and falling profit expectations.
One worrisome metric for Paulsen is low intra-market correlations, which means that there is a wide dispersion in returns among individual stocks. While savvy stock pickers can outperform the market in such an environment, Paulsen finds that it also tends to result in low total returns for the S&P 500 as a whole, based on history. "Since 1952, the average annualized forward 12-month S&P 500 total return has only been +4.88% when the correlation is in its lowest quintile!," he says.
Regarding equity valuations, Paulsen warns that a variety of metrics indicate that U.S. stocks are extremely expensive, based on readings that are significantly above historic norms. These include trailing P/E ratios and price/sales ratios for the S&P 500 Index (SPX), the ratio of total U.S. stock market capitalization to GDP, as well as the CAPE ratio. A recent report by Goldman Sachs finds that "S&P 500 valuation is stretched relative to history."
Also, the U.S. economy at full employment is unleashing inflationary pressures that are pressuring stock valuations by raising costs for businesses and constricting profit growth. Meanwhile, rate hikes by the Federal Reserve are boosting corporate costs as the Fed is reversing quantitative easing (QE), which propped up equity prices.
While stock market volatility has increased in 2018 versus 2017, Paulsen argues that it's still "remarkably low" this year despite two 10% corrections. "In stable financial markets, stocks struggle," he says. Nonetheless, as of the close on December 10, the CBOE Volatility Index (VIX) is up by 136% from its value one year ago, and 23% above its long term average, per YCharts.com. A recent note to clients by Credit Suisse finds that the current upsurge in the VIX indicates that "investors no longer see the market correction as a temporary dislocation, but rather driven by more persistent macro risks," as quoted by The Wall Street Journal.
Deteriorating profit expectations are Paulsen's sixth and final big concern. "Recent fundamental shifts now raise the possibility that 2019 earnings could decline which would likely be a shock to investors," he warns.
The extraordinary length of the current bull market and economic expansion, which began nearly 10 years ago, are making the onset of both a bear market and a recession increasingly likely in the near future, many investors and analysts say. Based on past studies, a bear market typically sends stocks down 30-40% and last at least a year to 18 months. A big question is how prepared many younger investors will be prepared for the downdraft, and whether panicked reactions of inexperienced investors may make the next one more severe.