It looks like the U.S. stock market may finally get something that happens, on average, about once a year: a 10+% percent drop, the definition of a market correction. The last time this happened was a whopper, the Great Recession dropped many U.S. stocks by over 50% in some cases. People today probably think corrections are catastrophic. They aren’t, corrections happen. More typically, they last anywhere from 20 trading days (the 1997 correction, down 10.8%) to 104 days (the 2002-2003 correction, down 14.7%). Even the nicest garden requires a good pruning to look its best again, so do the markets. Corrections are unnerving, but they’re a healthy part of the economy. Consider a couple of reasons:
- Reason #1: People buy stocks at earnings multiples which are designed to generate average future returns higher than cash or municipal bonds. Investors require a “risk premium” to compensate them for taking more risk, you should expect the bumps in the road for the opportunity to earn more reward.
- Reason #2: The stock market roller coaster is too unsettling for some investors, who sell when they experience a market lurch. This gives long-term investors a valuable and frequent opportunity to buy stocks on sale. This can lower the average cost of the stocks in your portfolio, which can be a boost to your long-term returns.
The current market downturn relates directly to the first reason, where you can see that bonds and stocks are always competing. Monday’s 4.1% decline in the S&P 500 coincided with an equally-remarkable rise in the yields on U.S. Treasury bonds. Treasuries with a 10-year maturity are now providing yields of 2.85%, hardly generous, but well above the record lows that investors were getting just 18 months ago. People who believe they can get a decent, relatively risk-free return from bond investments are tempted to abandon the bumpy ride provided by stocks for a smoother course of bonds. Bond rates go up and the very delicate supply/demand balance shifts, at least temporarily, in their direction, and you have the recipe for a stock market correction.
Last year saw great returns for most stock investors. January saw big returns on the expectations of tax cuts increasing corporate profits. We are midway through earnings season and 80% many companies are beating expectations. It appears the global economy has finally synchronized and much of the world is participating in the recovery, so who tossed the cold water on the party? You must remember the markets are a forward-looking animal. Interest rates have been rising since the fall and more rate increases are expected in 2018. There is concern we could be shifting into a more inflationary environment with higher GDP, lower unemployment, and global competition for resources. Maybe it was Janet Yellen’s final words of stock and real estate prices seeming high, not too high, but at the higher end of their normal range.
The volatility on Friday and Monday was interesting to follow. A very crowded trade on the street has been to short volatility, since there has been very little over the past year and instruments exist to do it…at least before a few halted trading. Crowded trades unwind fast. The market are not just people buying and selling, but lots of computers programmed to do “X” when “Y” happens. This has the potential to add market volatility and appears to have done such the past few trading days. What should investors do? Remember, you are not a trader, but an investor. Tuning out the short-term white noise of the markets is more important than ever. Stay the course and know you are taking the amount of risk appropriate for your goals and needs. Have cash on the sidelines? It may present a nice buying opportunity.
Investors may have gotten used to the lack of volatility in the markets over the past year. In the latter stages of any recovery you should expect an increase in volatility. While all kinds of events have caused corrections over the history of the markets, most bull markets end when the economy overheats and tips into recession. The new Fed Chair, James Powell, will try to tap the appropriate amount of brakes with interest rate increases to keep the economy just right, not overheat, and continue this economic expansion. Ironically, you want corrections along the way to prolong how far the markets can rise, without corrections valuations stretch too far and we increase the chances of a market crash. The economy remains healthy, so we appear to have some distance to go on this one and long-term investors should remain patient and prudent.
Please reach out with any questions, comments, or concerns. We appreciate your continued business and opportunity to be a steady hand in times of uncertainty.
Daniel D. Sands
CFP® | Principal @ Arenite Advisory
California Insurance License #0D95725
Securities offered through Gĕneos Wealth Management, Inc., Member FINRA/SIPC
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