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Ahead of the curve: Is a correction on the stock markets just around the corner?

January 25, 2021

A comment from Jürgen Lukasser, Chief Investment Officer of LGT Bank Österreich, on what is shaping up to be an intense next few days, with over a hundred U.S. companies announcing fourth quarter 2020 numbers and an outlook for the current quarter.

Ahead of the curve: Is a correction on the stock markets just around the corner?

The old master Andre Kostolany is probably right again this time. He believed that on the stock market 4 is never 2 plus 2, but always 5 minus 1. You just must have the nerve to endure "minus 1". Exactly this case could occur in the coming weeks. The earnings season enters an intense phase in the coming days: 118 companies in the U.S. will give an update on the figures for the fourth quarter of 2020, including the outlook for the current quarter. Among these companies are heavyweights like AT&T, Apple, Facebook and Tesla.

Stock markets have been able to carry much of the momentum from the fourth quarter of 2020 into the current year. This trend is driven by investor optimism about corporate earnings growth in 2021, and in this regard, the current earnings season can certainly provide information to help determine where we stand. "Buy the rumors - sell the fact" is a rule often heard in trading rooms in situations like the current one. Optimism has given the stock markets a tailwind, but where do we go from here? For this, it is perhaps worth taking a brief look back at 2020: In terms of the development of corporate profits, 2020 really does represent an "annus horrbilis". In retrospect, the peak was in the second quarter of 2020. Due to the numerous hard lock-ups, sectors such as energy, industry or the financial sector showed earnings setbacks such as those previously known to the generation of our grandparents in the 1930s. At the index level, the S&P 500 saw its results plummet by around 45% year-on-year, and in Europe the setback was even more severe at just over 50%.

Currently, expectations are completely different: According to an analysis by Ned Davis Research, investor optimism is currently at such an optimistic level that it has only been exceeded in 7.4% of all months since 1994. The mood is as extremely good, the optimism knows hardly borders. But not only the mentioned analysis goes in this direction, also well-known sentiment indicators, put/call ratios - all indicators strike in the same notch. The crucial question is therefore: Is there too much optimism in the market? And an honest answer to this question is: The indications are becoming stronger. The probability of a correction is thus increasing. This does not have to assumed of a Black Swan event.

In addition to the quarterly figures, the outlook of the companies will be of decisive importance. Investors are eagerly awaiting an update on the development of the companies' operating business. In this context, it should not be forgotten that one reason for the strong development on the stock markets of the year starting in April 2020 was primarily the willingness of investors to simply mentally write off the current year 2020. This year, there was nothing to be done for many companies that even had a good business model. As a long-term investor, however, one can make the decision to overlook the earnings shortfall of a single year if at least the subsequent years deliver a good earnings performance. In 2020, this was the basis for rising share prices - and rising valuations at the same time. As a result, valuations on the stock markets are so high that there are no valuation reserves for disappointments. This circumstance also increases the probability of a correction.

On the other hand, it must be noted that a correction in securities markets - provided the companies do not report any catastrophic news - is also not a disaster. Expectations and reality are thus brought back into line. And this lays the foundation for a healthy development on the stock markets. This is exactly what old master Kostolany meant by "5 minus 1".

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