Is This a Correction?

The stock market had a strong start to the year, and pundits are now warning that it’s due for a “correction.” Before we sound any alarms, let’s first analyze the history of corrections to pinpoint their root cause.

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 since 1942. While these numbers may appear frightening to some, consider the following facts:

1. Corrections Happen: Pullbacks greater than 10% are almost an annual event.
2. They Don’t Last: On average, paper losses lasted a few months.
3. Big Drops are Rare: The S&P 500 rarely falls more than 20%. Furthermore, the index has only seen six drops greater than 30% since 1950, or roughly once every 12 years¹.

Since corrections happen, let’s dissect a stock price using the formula below to understand the root cause.

Stock Price = Earnings x Valuation

Earnings are fueled by economic growth, competitive positioning, management experience, and other fundamentals that change slowly over time. For example, if the stock market drops 10% in a month, it is doubtful 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 felt like property values 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 for a house.

The same applies to stock prices. Corrections almost always occur because of a sentiment shift rather than any fundamental issue. An economy cannot move fast enough to drive that much of a change in the stock market. That’s also why corrections usually don’t last long. Sentiment is fickle, and the focus eventually shifts back to the fundamentals as long as they remain intact.

The bottom line

The chart below shows that an investment of $10,000 in the S&P 500 in 1970 would be worth over $2.2 million today. An average annual total return of almost 11% for half a century is not too shabby. More recently, an investment at the beginning of 2008 would have tripled by now, but this chart also depicts what you would have had to stomach along the way. It’s not just two of the worst recessions in modern history. There is a consistency in the pain inflicted, and it’s relentless. Bad things happen so frequently that it’s hard to remember them all, but they also tend to be forgettable.

Case in point. Go back to March 2021, when the NASDAQ 100 index fell over 10%. How many investors remember this? When was the last time pundits on television discussed this “bloodbath?” Or has it become a distant memory since the index ended that year up over 26%²?

There is also no reason to expect owning stocks to get easier anytime soon. Periodic pain is the price to pay for the returns offered by stocks. The trick to coping with this discomfort is remembering what volatility truly represents.

Think about it this way. Volatility is a measure of the short-term movements in stock prices. Since the daily ups and downs are driven by emotional reactions to events like the ones in this chart, then volatility is a measure of emotion. Hence, when the stock market gets more volatile, it’s just getting more emotional. Emotions are rarely strong enough to derail a $27 trillion economy, so most market temper tantrums aren’t a sign of any material risk.

Besides, forecasting human behavior is impossible (ask any parent). There are no Excel spreadsheets or regression analyses to use like there are to estimate earnings, cash flow, and other metrics that actually matter to stock prices over the long run.

That’s ok because corrections are also temporary. The data above confirm it, so there’s little value in predicting them. But don’t take my word for it. Peter Lynch, one of the greatest investors ever, 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 bottom line is that the real danger in the stock market right now is not volatility but how volatility causes investors to react. Keep emotions in check and focus on what drives stock prices over the long run.

Sources

1 https://www.capitalgroup.com/individual/planning/market-fluctuations/past-market-declines.html 

2 Bloomberg.

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. 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.