Are Investors Haunted by Corrections Past?

It finally happened.  After nearly four years, stocks suffered a correction in late August.  Sure, it hurts to lose money, just like it always does.  But I’m a numbers guy, so I find it helpful to review the historical record for the frequency and severity of such events, and more importantly, what to expect on the other side.

From its all-time high on May 21 to its recent low on August 25, the S&P 500 declined 12.35% against a backdrop of China’s currency devaluation, emerging markets weakness, and the potential for the Federal Reserve to finally raise short term rates from essentially zero.  A lot of headlines were written about stocks officially entering correction territory.  A correction is generally defined as a selloff of 10% or more, while declines of 20% or greater are termed bear markets.  For simplicity, I will refer to any decline of 10% or greater as a correction.

A review of market history from Yardeni Research shows 32 prior declines of 10% or more since 1945, ranging from those that barely qualify to the oil shock of the early 1970s (-48%), the tech bubble bursting in 2000 (-49%), and we all remember the financial crisis around 2008 (-56%).  Obviously not every correction leads to such ominous outcomes.  On average, in the postwar period we have seen a correction just over every two years.  There is no discernible pattern to timing or frequency, with eight corrections in the 1970s versus just two in the 1990s.  The average percentage decline is -21%, though individual instances are highly variable.  From peak to trough, the duration of corrections is also highly variable.  Average duration is 231 days, with some instances as quick as a few weeks and others longer than a year including the two-and-a-half year tech correction that ended in October 2002.

So given that corrections happen fairly regularly, and are by definition severe, why does the recent selloff feel so jarring?  In part, I think investors may have been spoiled by the recent market.  As noted, it has been nearly four years since the previous correction, longer than the two year average.  Even that correction, beginning around August 2011 with the backdrop of S&P downgrading US Treasury debt from AAA, was mainly contained to a brief two months and quickly put in the rear view mirror.  2014 concluded as the sixth consecutive calendar year of positive returns (including dividends).  It’s easy to see how the potential for a correction may have been shuttled to the back of the mind.  Other investors, with the memories of the severe bear markets of 2000 and 2008 still fresh, are quick to conclude that any selloff may be the harbinger of something far worse.  Having invested through those years myself, that concern is understandable.

Part of a financial advisor’s job is education.  Any discussion about the long-term positive average returns of stocks, bonds, real estate, or any asset class, should include the fact that those returns don’t arrive smoothly, year in and year out.  History demonstrates the certainty of unpredictable periods of decline with indeterminate length and severity.  Academic research, and our own experience, have convinced me that there is no reliable way of predicting and avoiding these corrections, at least without substantially altering your risk profile.  Note that avoiding corrections requires two accurate calls:  identifying the peak to sell, then the bottom to reinvest, plus the drag of friction, transaction costs, and taxes.  I know there are dozens of ways to make money in the markets, but I would be skeptical of anyone who claims to reliably avoid corrections.

What does a stock market correction mean for the broader economy?  Since stock prices reflect investors’ opinions about earnings and growth, the economy, interest rates, and enthusiasm, declining prices necessarily signal a net decline in at least some of those factors, although it is very difficult to attribute which ones.  S&P points out that all 11 postwar recessions were preceded by a correction, anticipated by an average of seven months.  Unfortunately, corrections also produced a lot of false positives for recessions, providing an accurate forecast only 35% of the time.  A correction is more of a yellow light, encouraging us to pay closer attention to our economic assumptions.  Most corrections pass without a sustained contraction in economic growth.  Bear markets have been more reliable recession predictors (67%).

For an investor, the key is to acknowledge the likelihood of correction periods, then focus on the long term.  Corrections come with the territory of equity investments, and the volatility they represent are part of the price of the higher long-term returns that stocks have historically provided.  The discipline to stay invested through the downturns is often the sign of a successful investor.  Keep in mind, stocks have recovered and then exceeded every prior correction, and I would not expect the current situation to end any differently.

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