The stock market has had a strong start to the year, but recent all-time highs followed by volatility in closely watched sectors appear to be fueling fears of an imminent correction. But before we even attempt to answer whether the stock market is due for a correction, let’s first define one, analyze the frequency of corrections, and attempt to gauge the root cause.
They Happen
A “correction” is defined as a drop of 10% or more in the value of an index. The table below provides some context around the frequency and severity of corrections in the S&P 500 from 1900 through 20191.
These numbers may appear frightening upon first glance, but consider three important facts:
- Corrections Happen: Market pullbacks greater than 10% are not only common, they average out to be an annual event.
- They Don’t Last: Paper losses lasted for a few months on average.
- Big Drops Are Rare: The S&P 500 has not fallen more than 20% all that often. Furthermore, the index has only seen six drops greater than 30% since 1950, or roughly once every 12 years2.
Since corrections do happen, let’s dissect a stock price using the formula below to better understand their root cause.
Stock Price = Earnings x Valuation
Earnings are fueled by economic growth, competitive positioning, management experience, and other fundamentals that tend to change slowly over time. Sudden moves in stock prices rarely depict abrupt changes in these. For example, if the stock market drops 10% in a month, it is highly unlikely that the average company’s future profitability could change that fast. What can change is how investors perceive the value of the stock market.
Think back to the housing market in 2008, when it seemed as if the value of properties dropped overnight. This did not happen because homeowners suddenly realized that all the concrete used to build the foundation of their homes was poured incorrectly. Instead, buyers left the market because they no longer wanted to buy or could qualify to buy a house.
The same applies to stock prices. Corrections almost always occur because of a sentiment shift rather than any fundamental issue because an economy simply cannot move fast enough to drive that much of a change the stock market.
That’s also why corrections are common but usually don’t last long. Sentiment is fickle, and the focus eventually shifts back to the fundamentals as long as they remain intact.
Who Knows?
When the stock market moves sharply, fickle or not, people want to know why. Market pundits are quick to comment because those who can provide insight are regarded as having a “feel for the market.”
But stock exchanges do not require traders to explain why they buy or sell stocks. Nor do the brokers that transact for their clients. In fact, large asset managers even go out of their way to maintain anonymity by trading in “dark pools,” which are special venues where activity is kept secret.
Instead, market commentary comes from a mix of sources that are often unreliable, such as large trading desks on Wall Street. These traders move millions of shares every day and are in constant communication with large asset managers making buy/sell decisions. The problem is that since most trading is electronic these days, their insight explains a fraction of the overall volume.
Said another way, market commentary is almost always nothing more than an educated guess. That’s not to say it’s inherently bad or useless, but rather a reminder to just take it with a grain of salt.
The Bottom Line
The chart below shows that an investment of $10,000 in the S&P 500 on January 1, 2008 would have grown to over $29,000 by December 31, 2020. Almost tripling your money with an average annual total return of 8.9% in twelve years is not too shabby, but this chart also reminds us what you would have had to stomach along the way.
It’s not just two of the worst recessions in modern history either. There is a consistency in the pain inflicted on investors, and it’s relentless. These events happen so frequently that it’s hard to remember them all. But there’s another reason why we don’t remember – they are often easily forgettable.
Case in point. Go back to September 2nd last year, and the NASDAQ 100 index fell over 10% in three days2. How many investors remember this? When was the last time pundits on television discussed this “bloodbath”? Or has it become a distant memory now that the index is up almost 14% since then2?
There is also no reason to expect owning stocks to get any easier anytime soon. This pain is the price you pay to position yourself for the potential returns offered by stocks. The trick is to change your perception on what volatility truly represents.
Think about it this way. Volatility is a measure of the short-term movements in stock prices. Since the day-to-day ups and downs are driven by emotional reactions to events like the ones in the chart below, then by association, volatility is a measure of emotion. Hence, when the stock market gets more volatile, it is really just getting more emotional. Sentiment is rarely strong enough to derail a $22 trillion economy, so most market temper tantrums aren’t a sign of any real risk.
The bottom line is that I have absolutely no idea if we will see a correction in the coming days, weeks, or even months. Timing these events is impossible, but don’t just take my word for it. Peter Lynch, one of the most successful investors of all time, said it best:
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
The real danger in markets is not volatility but rather how volatility causes investors to react. Keep emotions in check and remember what drives stock prices over the long run.
Three Key Points
- The stock market’s strong start to the year has fueled fears of an imminent correction.
- Corrections happen quite regularly but their root cause is rarely an indication of a fundamental shift in the stock market.
- The real danger in markets is not volatility but rather how volatility causes investors to react.
Sources
1https://www.capitalgroup.com/individual/planning/market-fluctuations/past-market-declines.html
2 Bloomberg, as of 2/24/2021
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. Richard W. Paul & Associates does not provide tax, legal, investment, or accounting advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.