The stock market continues to be in a state of euphoria, according to Citi’s chief US equity strategist Tobias Levkovich, and there is still a fair chance of a year-end correction. While Levkovich is bullish on equities in the long term, he warns that investors need to use “tactical caution” in the near term.

“Our Panic/Euphoria remained in Euphoria territory, while our proprietary Cyclical Expectations Model turned higher,” he writes. “We continue to think that a very late 2013 correction (in the 5%-7% range) is possible for equities (or it could slip into 1Q14) given weakening EPS forward guidance trends, a rolling over of the Citi Economic Surprise Indices in Europe, the US and G10- economies and softening in the Cyclical Expectations Model, not to mention euphoric sentiment levels.”

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Stock Market growing steadily

The Panic/Euphoria index indicates an 83% historical probability of a downward correction in the next year, but Levkovich says that it was expected the S&P 500 (INDEXSP:.INX) would overshoot and then pull back in the early stages of the recovery, hopefully growing steadily after that. He notes that by some measures the market appears as much as 20% undervalued, while by other measures it appears slightly overvalued. While he sides with the bulls, he seems to interpret the conflicting signals as further evidence that there will be a slight drop within the next few months.

The Citi results mesh with other investment firms’ research showing that investor sentiment is high, even if it’s not yet out of control. Morgan Stanley analyst Ronan Carr has similar advice for anyone thinking about putting money into equities. “While we maintain an overweight stance in equities, we would be wary of injecting fresh funds in equity markets here. We believe investors should be particularly watchful for any deterioration in liquidity flows,” writes Carr.

US and foreign funds flow

For now, liquidity flow are still positive, but they have dipped slightly. US-based funds had $1.04 billion worth of inflows while foreign funds had $4.39 billion in inflows last week and bonds had outflows of $3.24 billion. While that’s still a strong gain, the four-week moving average fell from $9.47 billion to $7.43 billion, exactly the kind of drop that Carr warned could be the canary in the coal mine.

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