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Stock market valuations have been a big concern to investors. And for good reason. Well regarded stock market valuation indicators like the total market capitalization-to-GDP (also known as the Warren Buffett indicator), the Case Shiller P/E, and price-to-sales ratios are all at historically astronomical heights. This has led a number of analysts to predict the S&P 500 could drop up to 30% or more in the “not too distant future.”

Are Concerns about a Stock Market Correction Exaggerated?

One equity strategist at Morgan Stanley believes the stock market is definitely going to take a breather. There is more than enough reason to at least heed his warning. The analyst, Michael Wilson, correctly called the last two big sell offs. He was also one of the first to declare a new bull market in April 2020, the first to warn of building inflationary pressures, and he downgraded U.S. small-cap stocks when they were peaking in March.

Why has Wilson turned sour on the S&P 500?

On Friday, May 7, the Bureau of Labor Statistics announced that the world’s largest economy added just 266,000 jobs in April. Analysts were looking for the U.S. to create one million jobs. Some were even predicting job gains beyond two million.

On top of that, U.S. unemployment inched higher, to 6.1% from 6.0%. Again, analysts were expecting the unemployment rate to fall. It was the Bureau of Labor Statistics biggest miss since 1998.

Underwhelming U.S. jobs numbers and unemployment data might have been bad news for the U.S. economy, but it helped lift the S&P 500 to record levels that same day. Investors are hoping that the Federal Reserve will need to keep interest rates low and maintain its generous monthly bond-buying program. This in spite of soaring inflation.

Wilson holds that weak jobs data and rising unemployment coupled with a red-hot economy, will result in supply chain disruptions and rising demand for workers, which could put the brakes on the U.S. economy.

Will Stocks Rebound when the Economy Reopens?

Despite the high unemployment rate, many leading brands, including Procter & Gamble Co (NYSE:PG), Coca-Cola Co (NYSE:KO), Taco Bell (a subsidiary of Yum! Brands, Inc – NYSE:YUM), and McDonald’s Corp (NYSE:MCD) are finding it difficult to get employees to return to work.

At this point, a reopening of the Canadian and U.S. economy could bring more risk than opportunity. That’s because rising inflation and rising labor costs could put a dent in corporate profits. The significant rise in virtually all commodities, especially lumber, copper, and crude oil, poses another threat to profitability—none of which is currently baked into today’s stock prices.

This does not mean the bull market is going to end, not with the massive economic growth expected later this year. But Wilson does think stock market returns will be flat for the year, accompanied by a 10% to 20% correction along the way.

He’s not the only one expecting the S&P 500 and stock market to experience a stock market correction. Another well-regarded New York portfolio manager believes a 30% drop or more in the S&P 500 is “highly probable” in the not-too-distant future.

One red flag that a stock market correction or crash is coming is the consistent periods of high volatility, with stocks rising and falling three percent or more in a single day. This took place in 1999, right before the dot-com bubble burst.

On top of that, the Federal Reserve is expected to announce later this year that it will begin turning the valves off their generous bond-buying program in 2022. Even the notion that the Federal Reserve is going to taper its bond buying could send Treasury yields higher.

In February, the U.S. 10-year Treasury yield spiked, which sent the broader markets tumbling.  The Nasdaq still hasn’t fully recovered.

But with the economy expected to open up in a spectacular fashion later this year, chances are good the Federal Reserve and Bank of Canada will have to raise interest rates to curb inflation. And we already know how investors will react to that.

Admittedly, it’s impossible to predict exactly when there will be a market correction, but we know one is coming; that’s because the economy and stock markets are cyclical.

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