Why the risks of a market correction for the ASX 200 is rising

ASX investors may feel like they are stuck in no-man’s land! The S&P/ASX 200 Index (Index:^AXJO) is struggling to convincingly break above 6,000 but bargain hunters won’t let the market fall too much either.

It’s a nail biting time as we are torn between hope that the worst of the economic impact from COVID-19 is behind us and fear that the share market is caught in irrational exuberance.  

While I am siding the bulls in this Mexican standoff, Macquarie Group Ltd (ASX: MQG) is warning that the risks of a market correction are rising.

Swamped by a second wave

There are three reasons why the broker believes the S&P 500 will fall, which will likely pull our market down too.

First is the prospect of a second wave of coronavirus infections. Macquarie doesn’t think the chance of a significant rise in COVID-19 cases is very high and a second wave of shutdowns is unlikely.

But it did note that Google data points to an increasing risk of this happening with searches for COVID-19 on the rise. There is a 93% correlation between such searches and the S&P 500, although this correlation has been weaker in more recent times.

Liquidity risk

The second factor is the US Federal Reserve (Fed), which recently withdrew liquidity from the market.

“The Fed’s balance sheet contracted last week, driven by reductions in Repo and Swaps,” said Macquarie.

“As both were introduced to ensure smooth market functioning, the market has been less concerned by these falls.

“But when Fed liquidity has been a key support for equities, further shrinking of the Fed’s balance sheet would add to the risk of a correction.”

Optimistic valuations

Lastly, valuations are causing concern to the broker who noted that the forward price-earnings (P/E) for the ASX 200 is 19.3x. This is 3% above its pre-pandemic high.

Even if you looked out the following year, the forecast P/E dips to 17 times, and that’s a mere 4% below the high before COVID-19.

“High valuations alone do not cause a correction, but they do make the market more susceptible to negative surprises,” added Macquarie.

“Too rapid withdrawal of fiscal stimulus would be a negative surprise for the market.”

Reasons to be optimistic

The warning from the broker isn’t what many investors want to hear, but there is a silver lining. If we do experience a big pullback, the fall may not be as bad as the bears are anticipating.

The broker estimates that the S&P 500 would fall by 6% to 7% but the ASX will not fall as much as it’s managing the coronavirus risks better.

Further, the earnings per share (EPS) rebound is going better than what many sceptics expect.

“Net EPS revisions have shown a V-shaped recovery, supporting stocks. From a low of nearly 80% net EPS downgrades on April 22, net EPS downgrades were down to 15% on June 22,” said Macquarie.

This means the August profit reporting season may not turn out to be a disaster, as what many fear. Macquarie’s estimates suggest net revisions could continue to improve in the upcoming results season.

All the more reason to buy the dips!

More reading

• Should you wait for another market crash to invest in ASX shares?
• ASX 200 finishes higher, Afterpay hits new record
• The latest ASX 200 stocks to be slapped with a broker downgrade
• 3 ASX shares I’d buy if the market crashes again
• Is the share market facing another February 2020 moment?

Motley Fool contributor Brendon Lau owns shares of Macquarie Group Limited. The Motley Fool Australia owns shares of and has recommended Macquarie Group Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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