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Stock Markets Hit New Record: Time for a Correction?

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The last couple of weeks have been bullish for the stock markets, generally speaking. Just yesterday, the Nasdaq and the S&P 500  logged new all-time highs. The Nikkei finally recovered from its ’80s bubble to reach levels not seen in over thirty years. As the markets rise, they are seen as increasingly “frothy”. Does that mean a reversal in risk sentiment can be expected? And how will that affect Forex?

One of the signs of potential trouble is that institutional investors have been pulling their money out of the stock market through February, signaling concerns about a possible market correction. Meanwhile, retail traders have been jumping in the market, with over $5.8B in net inflows from small traders. Part of that phenomenon is attributed to large investment houses taking profits following the gains in AI stocks, such as Nvidia.

Taking Profit Ahead of a Downturn?

Institutional investors selling after a large surge in the market is normal, but so is a correction in the market. A pullback from the most recent high by 10% technically meets the definition of a correction, and doesn’t necessarily imply there is a change to trend downwards. This opens the question for traders if a move lower happens in the short term, whether it’s actually an opportunity to buy the dip and capitalize on the market correction Before getting too optimistic, though, analysts have been warning for months about the lack of breadth in the market. That is, there’s been a really small number of companies that have been pushing the stock indices higher. The “magnificent seven” of mega cap, AI-driven tech firms have been responsible for virtually all the growth in the stock market. Take those companies out, and the average performance is actually negative from last year. Meaning that the latest move higher is particularly vulnerable.

What Does the Data Say?

The most recent figures from the US provide indications in opposite directions. Key growth markers, such as durable goods and PMI were worse than expected. US Q4 GDP was revised slightly lower. By themselves, they don’t indicate a warning of a recession. But the economy might not be as resilient as initially thought, which could make it harder for the recent gains in the stock markets to “broaden out” to other companies in other sectors to make the gains more durable. On the other hand, the recent inflation data has been below expectations. This dovetails with slower economic performance, as the rate of inflation typically correlates with GDP growth. But that could be good for the stock markets and risk appetite in general, as it would mean that the Fed is more likely to cut rates sooner, and by a larger amount.

Where to from Here?

Not just in the US, as slower inflation in the Euro Area has also raised hopes that the ECB will get around to cutting as well. That helps explain the recent gains in European bourses. But rate cuts are still months ahead, and the market has plenty of time to go through a correction between now and then. It is, of course, possible for the markets to keep making new records for several months. It’s just not the usual. The last earnings season showed that, AI aside, corporate earnings were lower than the prior quarter. That pushed valuations for the stock market to the highest they’ve been in almost two years. Analysts expect next quarter’s earnings to be an improvement. But, from here to mid-April, there are indications that the stock market is overvalued.

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