Plan For A Correction In H2 2025
Stocks are overvalued, smart money is selling to dumb money and technicals are peaking or rolling over.
I have been reading dozens quarterly and semiannual reports from analysts the past week and I have seen comparisons to 1999, 2007 and 2021 with some frequency. All of these analysis provide evidence to support their base case thesis, along with alternative scenarios.
The alternative scenario that has become my base case is 2018. I believe it holds the most parallels to what we are seeing in 2025, as I will lay out below.
If my 2018 "base case" scenario plays out in the second half of the year, then we will see a rise in volatility and correction of 15% to 30% in stock markets.
Other scenarios are possible, but, given the "uncertainty" of tariff policy, policy reactions, both domestic and international, as well as, debt issues that are becoming more severe, I think the alternative scenarios are generally worse than 2018, not better. That said, better could play out, at least for a while.
Remembering that markets can remain irrationally exuberant a long time before corrections happen is important. We need to have some participation in rising equity markets, even if we don't think valuations make much sense in the short term, while still managing risk.
To do this, we stick with our best ideas where there is a chance for outperformance. In this way, even if we are not fully allocated to our normal level of equities, if the equities we do own are better, we can hold the extra cash as a safety net.
By not trying to be too perfect, we protect ourselves from being wrong in our pessimism, which is a natural tendency. We are emotional no matter how much we try to control it. We are fallible no matter how smart we are.
Carrying extra cash in accounts is the best hedge for most people. Other methods of hedging require so much precision to execute well, that few are able to make those trades effectively.
Knowing that stock markets have always been higher sometime in the future, is a reminder to buy the "dips" incrementally as the corrections become deeper. I plan to use extra short-term cash (your hedge) to scale into corrections, small, slow and at wide price points.
The alternative scenario that has become my base case is 2018. I believe it holds the most parallels to what we are seeing in 2025, as I will lay out below.
If my 2018 "base case" scenario plays out in the second half of the year, then we will see a rise in volatility and correction of 15% to 30% in stock markets.
Other scenarios are possible, but, given the "uncertainty" of tariff policy, policy reactions, both domestic and international, as well as, debt issues that are becoming more severe, I think the alternative scenarios are generally worse than 2018, not better. That said, better could play out, at least for a while.
Remembering that markets can remain irrationally exuberant a long time before corrections happen is important. We need to have some participation in rising equity markets, even if we don't think valuations make much sense in the short term, while still managing risk.
To do this, we stick with our best ideas where there is a chance for outperformance. In this way, even if we are not fully allocated to our normal level of equities, if the equities we do own are better, we can hold the extra cash as a safety net.
By not trying to be too perfect, we protect ourselves from being wrong in our pessimism, which is a natural tendency. We are emotional no matter how much we try to control it. We are fallible no matter how smart we are.
Carrying extra cash in accounts is the best hedge for most people. Other methods of hedging require so much precision to execute well, that few are able to make those trades effectively.
Knowing that stock markets have always been higher sometime in the future, is a reminder to buy the "dips" incrementally as the corrections become deeper. I plan to use extra short-term cash (your hedge) to scale into corrections, small, slow and at wide price points.
Valuations Are Historically High
In the long run, valuations drive stock values. In the short term though, stock prices largely move on emotional market sentiment and momentum. By analyzing fundamentals and short-term technical analysis, we are working to manage risk, while finding opportunities.
Right now, I am finding far more securities "priced for perfection" than those that are undervalued against my analysis of future business outcomes. Because risk appears higher than normal, and opportunities are fewer, I am consistently managing my risk on rallies, and doing less selective buying.
Here is a proxy for the famous Buffett Indicator, which measures stock valuations against GDP.
According to this metric, the broad stock market is at its most richly valued in history. Note that other periods when this metric hit an extremes, we typically saw a range of corrections and crashes.
Several other measures of price to earnings also indicate high valuations.
These measures also show record highs or near record highs on valuation.
Such high valuations do not "require" a stock market crash. But, it does demonstrate a higher level of risk likely being present. Investors should take note of this in relation to your risk tolerance.
Another measure, called the Case Schiller PE Ratio measures the current Price/Earnings ratio of the S&P 500 (SPX), which is the most heavily invested index of large cap stocks, represented by ETFs such as the SPDR S&P 500 ETF (SPY) and Vanguard 500 (VOO), relative to historic measures.
This PE measure is misunderstood as a short-term indicator. Rather, it is directional forecast for expected average returns over the next decade based on historical norms.
Case Schiller PE will never be "right" for exact returns, but it has been very good at forecasting whether returns in the next decade will be above or below average. Right now, it is forecasting dramatically below average returns the next decade.
The current Case Schiller PE ratio is over 35 right now. That indicates price return on the S&P 500 could be close to zero over the next decade. I would point out that during the QE age, the skew has been higher returns than the earlier part of the data set.
I think that means that if we continue QE on any crisis, crisis scare or economic excuse, then we will continue to see returns skew higher on average until there is a complete break in the system. Such a break might never occur or it might happen soon. There is no way to know.
Volatility Set To Rise
Volatility in the S&P 500 has been dissipating since the spring spike and is about down to the long-term average. It can head lower in the short run. It is also likely to see another spike within roughly a year or less.
What can cause a spike in volatility? It's a long list.
The most immediate potential spike in volatility is the next wave of tariff news coming soon.
The most severe potential spike in volatility, I believe, would be a potential credit crisis that I have been discussing this year.
And, there are any number of unknown unknowns, or "black swans" that could occur, such as terrorism, a climate event, a pandemic or aliens.
My reading of history leads me to believe that any crisis can be counteracted with policy responses though. The problem is that we don't always get the "medicine" right the first or second or third time.
The most popular form of "medicine" since the Global Financial Crisis has been quantitative easing, aka, QE. While it's not exactly printing money, it's close enough that is what folks call it and understand it as.
I expect the Federal Reserve to engage in QE again, and probably again, in the next decade. That means potential inflation and recessions, volatility, risk and opportunity, in somewhat cyclical patterns. The business cycle is not dead.
QE "medicine" can cause side effects. Warren Buffett discussed how QE could cause inflation back in 2008. We did not get inflation until the pandemic QE which was the 5th round of that sort of "money printing."
If you read that closely, and with some economic background, you'll know I am referencing both Keynes and Hayek in this section. And, here is where I lean into a quote probably incorrectly attributed to Winston Churchill:
Americans can always be trusted to do the right thing, once all other possibilities have been exhausted..."
In this way, I expect America, increasingly being led by the Millennials, to eventually correct many problems of the past 45 years. I believe those problems include underinvestment in education, infrastructure and the retirement system, extreme inefficiency in healthcare, as well as, tax and regulatory policies that skewed most wealth (estimates suggest about 70%) to the richest 1% of the population.
That does not mean I lean socialist. It means I want capitalism fixed, even though it is the worst system, except for all the others. I think the majority of Millennials essentially agree with that sentiment.
I discuss these issues, which toe the line of politics, because they matter in the context of the direction that markets are likely to take. Having a better understanding of how the economy and political systems work, are among the keys to investing.
The key phrase I use repeatedly to help myself and others understand what is happening and why it is happening is in a phrase passed down through at least a few generations in my family: "follow the money."
If we follow the money, then we can understand the volatility events that occur, which will help us control our emotions. In turn, that will help us follow the money into what could be great investments.
So, what do we do if there is a volatile event (there will be)?
We hold our nose and slowly buy what we consider to be the best assets, while others are panic selling. By waiting a bit, then scaling in, we can build a margin of safety through buying cheap and essentially getting a playground style "re do" to buy stocks in great companies.
Big Secular Trends And Value
What are the best assets? That is a loaded question that is a bit easier to answer than I think people realize.
The best assets, in my mind, are the ones that provide the most total return in price gain and income produced, without taking excess speculative risk. We are looking for two sorts of assets then:
Assets that take less risk than the markets, but provide a similar total return. In this way, we are getting the value of lower risk, but with equity returns. In my opinion, there are very few stocks in this category, but there are several ETFs and a handful of other sorts of funds.
Assets that take market similar risk, but provide more total return. Here is where we get our value in performance. These are the more common assets, and include stocks, ETFs, other funds and other asset classes, such as, currencies, metals, minerals, food stuffs, gold and Bitcoin, etc...
Where are we finding "the best" assets? Mostly, but not exclusively, I am seeing great investments in the big secular trends, and second derivatives of the big secular trends.
Let's remember that "money at the margins" is usually what changes price. That is, the last buyer or seller, is who sets the prevailing price. This is an Econ 101 concept. So, while Baby Boomers have the most money in America, the Millennials are the biggest current new investors, by far.
I wrote a few years ago that Millennials will drive markets going forward the way Boomers did from the 1980s until about a decade ago. That has indeed been the case the past several years, especially since Covid.
It is important to understand that Millennials largely invest in the secular economic trends, they are that sophisticated and they do tend to avoid "old Boomer" investments that don't play to their ideas of the world, what the world is becoming and should become.
The secular trend with the most people talking about it is "AI" or artificial intelligence. AI is a 4th Industrial Revolution technology that will impact most aspects of business and life in the coming decade if the past few years is an indicator.
The broader 4th Industrial Revolution has massive implications. As described by Salesforce (CRM), it includes the following:
In that group, which also includes alternative energy, medical devices and more, is where I see tremendous opportunities in providers, but also users of these advanced technologies.
Ultimately, the 4th Industrial Revolution impacts supply chains, the nature of employment, the flow of capital and geopolitical relations.
4th Industrial Revolution 2nd derivative winners are likely to be companies that use 4IR to increase revenues and margins by using technology to improve their businesses with lower added expenses than in the past. You can read that as less labor.
4th Industrial Revolution losers will be those companies that are slow to adopt technology, misapply technology, otherwise mismanage the shifts, or simply let their businesses get sucked dry while they wither away. I expect a lot of smaller businesses without the expertise or money to adapt, to suffer here. That opens up opportunities for consolidators, such as private equity, and bigger companies in general.
Another major secular trend is aging demographics. As life spans increase and birth rates decline, the nature of the economy shifts. This is a multiple book length topic, but the baseline to understand is that the nature of consumption is shifting with an older population.
Climate change, regardless of how you think it is happening (hint: it's us burning fossil fuels), is also having a dramatic impact on everything from weather events, to supply chains, to migration patterns.
Don't believe me? It's not just academics and business executives talking about climate change. The Pentagon has been talking about climate change for over two decades.
I think, hear me now believe me later maybe, is that there will be events over time that drive policy to focus on this problem once again. That will mean more clean energy, which is already providing about 90% of new electrical generation in America, but also substantial changes to what we produce and how we produce it.
Right now, there is a negativity to clean energy and greener manufacturing investments. Our job is to be contrarian and forward looking to find the survivors, often trading very cheaply, for the next bull market cycle.
Importantly, one of the biggest clues to which industries and companies to invest in, is to look at past performance from the last cycle. While regulators will require a disclaimer of "past performance is no guarantee of future results," it is my experience and data supports this, that many stocks that did well in the last bull market [up] cycle, tend to do well in the next one.
Conversely, usually things that make sense happen. That means some companies that are out of favor now, will do well in the future, despite current pessimism. Finding those companies is just another form of value investing.
As Charlie Munger said, "all investing is value investing." My interpretation is that whether we are looking for growth assets or income generating assets, looking for past winners that will continue winning, or companies out of favor that will find favor, we are looking for a margin of safety offered by prices that are lower than our analysis of the intrinsic value of a company, commodity or currency.
I focus primarily on companies with secular tailwinds, but the value of commodities and currencies play a macro role we pay attention to.
What's Next?
So, I buried the lead, but I wanted to get you into my head a bit.
I don't know what comes next. Ha! Anyone who tells you they do, is lying to you, themselves or both.
What I do know is that risk is high. And, it's higher than just the valuations, or tariffs or debt. It's an all-of-the-above answer. Importantly, the narratives being discussed, ad nauseum, has an uncertain order of operations, despite so many offering certain conclusions, making conclusions difficult.
We are best off by understanding the range of potential outcomes, rather than marrying one rationalized scenario.
Let's start with the tariffs. I know is that the manufactured U.S. economy is 70% American made. Services are almost entirely U.S. based. As of 2023, imported goods and services, were about 86% domestically based.
With that being the case, the impact of tariffs on inflation will not be very high, although, there will be an impact. Most estimates are that we will see a 3% to 6% impact on the overall price level by next year. This is still in flux due to not knowing exactly what tariffs will be, but, from what I am reading, the 3-6% range is pretty consensus.
That is probably enough for the Federal Reserve to be cautious on cutting interest rates. While I am no big fan of the current administration's policies in general, I do actually agree that it would be nice if interest rates were lower.
The problem is not the Federal Reserve though. Those are short-term rates that the banks use, not borrowers of U.S. debt. If the Fed Funds rate were a bit lower, that would not have much impact on things like car loans, mortgages or business loans, which are longer term.
Interest rates are not falling at the 5-year and longer durations for U.S. Treasuries, which do impact car loans, mortgages and business loans, in my analysis, because of the debt problems I describe in the article linked higher up in this piece.
The new budget bill that just passed is going to increase the deficit by all accounts. The last three times we passed a budget like this, under Reagan, George W. Bush and the first Trump administration, we were promised growth would be higher than the debt incurred. As we can see, debt to GDP continues to rise, and has been worse during all three deregulatory and tax cut regimes.
I believe that over the next several years, we will see this line continue up and to the right. Not a good outcome. Bad. Very bad.
Here's the complication, tariffs have irritated a lot of people around the world. So have other Trump Administration policies. Those same people have often been the people who supported our debt and our currency.
So far in 2025, the dollar is down about 10%, despite the Federal Reserve not printing money, in fact, they have been un-printing money, aka, quantitative tightening, or QT, for about 3 years.
The dollar falling is a result of a loss in confidence in the dollar. This will also have an impact on inflation very soon.
While the dollar will remain a reserve currency for a very long time in my opinion due to the inherent advantages of the U.S. economy, geography, legal system, military, technology, financial system, labor force, etc..., it can suffer down cycles due to government policy and financial weaknesses.
I generally agree with what Ken Rogoff recently said: "My thesis is that the U.S. dollar is about to get knocked down a couple pegs. It will still be first in global finance, because nothing is poised to fully replace it. The dollar just won’t be as unique as it once was...”
Longer term, I think the dollar makes a huge comeback, but, over the next few years, we could be in for a reckoning.
Here's the biggest wildcard. What if foriegn investors reduce the amount of U.S. Treasuries they have been buying before this year. So far this year, the numbers have been choppy to negative.
According to the U.S. Treasury Department, foreign central bank ownership of U.S. Treasuries is down $48 billion. Only about $8 billion of this is China. They had been the notable seller since 2014. New sellers are emerging.
Since March, foriegn participation in Treasury auctions has hit multi-year lows. These could certainly be short-term anomalies, but what if they are the start of a trend? The answer is higher interest rates.
Jeffrey Gundlach, CEO of Doubleline and known as "the bond king," recently warned again that foriegn investors could withdraw more capital from U.S. markets. Gundlach suggested 20 and 30-year yields could rise to 6-7%.
What happens to the economy if rates go higher, not lower? We likely get a recession.
What happens in a recession? Unemployment rises, retirement plan contributions decline, the stock market has a correction or crash.
Here's the thing, American Exceptionalism and U.S. economic resilience has proven to be real. Can that offset higher rates and capital withdrawals from abroad? Very unlikely.
A Potential Spiral Down
To open this piece, I said my base case was a 2018 scenario. Look back at that year. The year opened with a volatility and a correction, then a sharp recovery. Very similar to this year.
Late in the 3rd quarter, things started to deteriorate, and then the 4th quarter suffered a significant correction. We'll see if this year follows. I think odds are high that markets will behave similarly, i.e. history will rhyme.
Here are the factors that contributed to the 2018 Q4 correction, per my recollection and understanding:
Higher interest rates than previous year.
Escalating trade war with China.
Fear of a slowing global economy.
Concerns over corporate earnings.
Technical exhaustion.
Government shutdown.
While we will not get a government shutdown, we are seeing essentially all of these factors once again to an extent. I have not shown the market technicals yet, so let me put that in now.
To start with, technical indicators are not a magical be all and end all, but, I have learned over 30 years managing money, that people who do not respect the technicals, tend to have more bad outcomes than I have, as someone who respects the technical indicators. In my opinion, respect the technicals, even if you use AI generated analysis, which, I have largely gravitated to because I don't have time to draw pretty pictures.
What we see in the chart above are a number of indicators. Let's start with the bullish. The trend, represented by the green dashed channel, is clearly up. We have not broken out of it to the upside and are past the midpoint now.
So, while the pattern recognition shows a bit higher to push, there is not a lot of upside without a catalyst to breakout to an even higher upward slope. I would note, and consider the valuations section above, the slope of this uptrend is already extreme.
Now the bearish, essentially, everything else. That's no joke.
The weekly RSI is in overbought territory. This is not the daily or hourly measures that traders use. Weekly RSI is measured week over week, and when it gets above 70, as it just did for a second time this year, it generally indicated a correction in the short term.
The weekly RSI is overbought for the second time in a year, that has historically been a very bearish indicator. The Bias and Sentiment Strength is also approaching overbought, though could trend a bit higher for a few more weeks or months. And, the Wyckoff Volume indicates about the same. If, I had to estimate, I'd think a correction could start in the next 8 weeks based on my understanding of these technicals historically and the current backdrop.
What weekly RSI, and the other mentioned indicators, do not tell us is the magnitude of a coming correction. We have to move onto other indicators for that.
My favorite is Institutional Fair Value Gaps and Liquidity Range Candles. In short, this measures where prices trend toward as institutional liquidity changes. The yellow band is the strongest "magnetic" range based on recent history. We can see that would be a correction in the 15-20% range from here.
If we have a debt crisis or significant enough scare, then the lower ranges open up. The red horizontal line in the price range during the 2022 correction. I do not see a world in which that is out of range. In fact, I think it is very possible prices head to that area if liquidity becomes a problem.
In a real credit crisis, something that the Federal Reserve cannot stop without Congressional intervention, the downside is steeper.
Following The Equity Money
There are two predominant trends in what is happening among U.S. equity buyers and sellers.
U.S. retail investors, aka, the little guy, have been large on net buyers of U.S. equities the past several months. Retail investors set a record purchasing $155 billion in net equity investments in the first half of the year according to Vanda Research.
International investors, who tend to be sophisticated, have been trickling out of U.S. equities. According to Goldman Sachs (GS), international investors have sold over $63 billion of U.S. equities as of the end of April, and that number is likely higher now.
Essentially, international investors have been selling to U.S. retail investors.
Since most U.S. retail equity buying is through funds in retirement plans, if unemployment rises, then the stock market generally corrects. Unemployment levels, not the percentage, but the actual full-time work force numbers, is the easiest shortcut to take for advance notice on a stock market correction.
This reminds me to discuss "dumb money" again. Dumb money is essentially "trend following" money, whether by design or complacency. Right now, the dumb money is flowing. Here is a widely followed chart.
I don't subscribe to this service anymore due to AI doing the data accumulation for me now, but I like the chart. If you look closely, you'll see that as the Dumb Money Confidence gets above 70, a correction becomes more likely. This is representative of late cycle behavior, especially when it happens two or three times (called drives in other technical jargon) in a short period of time, i.e. multiple late rallies indicate a fall, usually bigger, coming.
Again, magnitude is not indicated by the Confidence level on its own, but, the indication of a coming correction, like weekly RSI, BASS and Wyckoff, holds pretty consistently over time. Magnitude is hinted at by multiple overbought readings in a shorter period of time, think under 2-years, but especially within a year, like, 2018.
Closing Investment Thoughts
I have painted a bearish picture. It's not as bearish as it could be. We have to wait and see if we really do have a significant debt crisis or just a scare.
I have not said "sell almost everything" yet, because we don't know we are about to crash. I have only issued that warning a few times in my career: 1999, 2008 and 2020. I don't think this is quite like those, although, I do think the new budget bill gets us there in a few years.
The TLDR version is this:
The stock market is overvalued.
Smart money is selling to dumb money.
A debt problem could be the catalyst for a significant correction.
A debt problem is closing in, we just don't know how fast.
A slower economy could be the catalyst for a significant correction.
A slower economy could happen with disruptions from tariffs.
Any number of black swans could occur causing a correction, I'm particularly fearful of a terrorist attack after listening to various national security experts recently.
Higher unemployment would hit the S&P 500 since half of all U.S. equity flows are into the S&P 500 and the biggest contributing source is retirement plans.
It pays to raise cash by trimming or selling stocks, ETFs and funds that are highly correlated to the S&P 500 (like S&P 500 ETFs) since that is where half of all investor money goes now.
It pays to keep your best ideas which are less correlated to the S&P 500 because you have a chance to outperform if your ideas are truly good.