Goldman Sachs Model Signals That Stocks Could Drop A Lot

Goldman Sachs Model Signals That Stocks Could Drop A Lot
Stéphane Renevier, CFA

about 1 year ago2 mins

Mentioned in story

A “large correction” is what we call it when stock prices drop over 10%, and three factors increase the risk of that happening within the next 12 months: high valuations, a weak economy, and elevated volatility. I’ll walk you through the hows and whys.

When valuations are high, investors tend to be overoptimistic and are less focused on keeping a “margin of safety” in case something goes wrong. Any market shock, then, could quickly provoke a large correction as investors scramble. We saw that happen at the beginning of this year, when elevated valuations exacerbated the shock caused by rising inflation and interest rates. The good news, though, is that valuations have already corrected a lot this year, so they represent a much lower risk today (dark blue line in the chart).

A weak economy puts companies’ earnings at a higher risk of suffering after a shock, which makes their stock prices more vulnerable in turn. And Goldman believes that the current weakness in the economy is a significant threat right now: in fact, the probability of a large correction over the next 12 months shoots up to above 70% when today’s economic weaknesses are added (light blue line).

Finally, the risk of a correction heats up when investors expect volatility to be high. See, investors usually have good reasons to worry, so often a higher level of anxiety corresponds to a higher probability of something actually going wrong. And while volatility isn’t as big a threat as the weak economy at the moment, it still indicates a 60% chance of correction (orange line).

Today, Goldman’s model shows that the risk of a correction is not only higher than it has been historically, but that it’s still rising. And while that doesn’t guarantee that a correction will happen (it’s all about probabilities, remember), you might want to factor in that possibility when making your investment decisions. Plus, you can always focus on the upside: a correction could provide you with a great opportunity to buy at lower prices.

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