MIZUHO: 'The market appears at risk for an unexpected event'

Mizuho Securities has had just about enough of this pesky, ultra-resilient stock market. And it’s not backing down from calling a correction.

The firm sees conditions that are ripe for a decline of 10% or more. Mizuho’s biggest concern is that stocks are expensive, especially when compared to the rate of US economic growth and corporate profitability.

This will be proven increasingly true as the yield curve flattens amid flagging inflation, according to Mizuho. Also worrisome to the firm are historically subdued price swings, with volatility sitting close to the lowest in 50 years.

“Implied volatility has dropped to levels where the market appears at risk for an unexpected event to cause a reassessment by investors,” Mizuho chief US economist Steven Ricchiuto wrote in a client note. “Domestic financial markets appear expensive and due for a correction.”

Calls for major equity sell-offs during the ongoing eight-year bull market have been largely met with a shrug. In a pattern that’s repeated itself several times in recent months, traders react to share weakness by simply adding to positions at discounted prices. That “buy-the-dip” strategy has been a major saviour of the equity rally.

Just a couple of weeks ago, the S&P 500 dropped the most in eight months, only to recover most of the loss in just two days.

Following the UK’s vote last June to leave the European Union, the S&P 500 fell by 5.3% over two trading sessions, only to make up those losses in about a week. The same dynamic was in play when China unexpectedly devalued its currency in August 2015. After the S&P 500 underwent an 11% correction, traders bought the dip and restored the benchmark to its pre-sell-off levels within about two months.

In the end, the US stock market is expected to rely on expanding profits to keep valuation metrics such as the price-to-earnings ratio in check. S&P 500 earnings growth is expected to be 12% for the full year 2017, according to estimates compiled by Bloomberg.

Anything short of expectations may attract more attention to another bear argument made by Mizuho: While profits are expanding, earnings yields are basically the same as what a trader can get in the riskier areas of the bond market.

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