We need a market correction, and we’ll get one

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You can say this for market turbulence: It sets up better days ahead.

The year is only seven trading days old, but already it has delivered enough of a jolt to make you wonder what the rest of the year is going to look like.

The S&P 500 has fallen for four of those seven days, for an overall dip of 0.3 per cent in 2014. While that's not enough to make anyone sweat, it does mark the index's worst start to a year since 2008 – an ominous comparison, given that the S&P 500 wound up sinking more than 38 per cent that year.

There is little hard evidence to suggest the start of a year dictates its overall direction, but this particular start comes with many worries that make these early days look like a warning sign at best.

Consider that the S&P 500 hasn't experienced an official correction of 10 per cent or more since August, 2011. That's closing in on two-and-a-half years ago, and compares with a historical average of less than eight months between corrections.

Even most bullish Wall Street strategists agree that we're long overdue for a rough patch.

Perhaps the improving economic backdrop has lulled the market into a belief that where the economy goes, stocks are sure to follow. It's true that a lot of things are getting better: The U.S. unemployment rate has fallen to 6.7 per cent, or its lowest level since October, 2008; the economy expanded by 4.1 per cent in the third quarter; and the housing market continues to recover, providing a nice tailwind to economic activity.

But the improved economy means that the U.S. Federal Reserve is now tapering its bond-buying stimulus program, known as quantitative easing, and no one really knows what that's going to do to stocks. After the previous two rounds of quantitative easing ended, in 2010 and 2011, the S&P 500 fell 15 per cent and 23 per cent, respectively.

So far, the Fed has managed to head off a similar dip by stressing that it will keep its key interest rate near 0 per cent for a lot longer than some observers had expected. But the impact in the coming year is still a big mystery, exacerbated by the fact the Fed will soon be led by a new chair, Janet Yellen, with a potentially different view on economic stimulus.

And if that's not enough, there are always earnings to worry about. Corporate earnings have surged in recent years, providing fuel for the bull market in stocks. In recent quarters, though, stock prices have been rising at a faster pace than earnings, stretching valuations to levels that suggest the market is a tad expensive, at more than 17-times earnings.

If you use the Robert Shiller cyclically adjusted price-to-earnings ratio – where earnings are averaged over 10 years and adjusted for inflation – the S&P 500 looks overvalued by more than 50 per cent.

Now, as U.S. companies get ready to report their fourth-quarter results, it is hard to see much enthusiasm. An amazing 108 companies in the S&P 500 have already reduced expectations, compared with just 11 companies that have raised them, according to Thomson Reuters.

Alcoa Inc. reported its results on Thursday, with a thud. The aluminum producer, once seen as a bellwether stock, lost $2.3-billion (U.S.). Even after adjusting for non-cash impairments, earnings missed expectations, sending Alcoa shares down 58 cents, or 5.4 per cent, to $10.11 on Friday.

With earnings, Fed policy and an overextended rally weighing on the S&P 500, it is hardly surprising to see stocks sputtering. But if the bull market is to retain a healthy glow, a bigger pullback is needed. It will make valuations look more attractive and ease concerns that the stock market is yet again diverging from fundamentals.

Corrections can be painful, but only if you're not prepared for them.