Market Correction: That’s a Good Thing

Everyone in financial services has been shocked at the complete lack of volatility (prior to this past week). The MSCI World Index increased every month in 2017, a feat that had not occurred in the previous 30 years. So, instead of taking a breather, the markets accelerated their growth in January. The S&P 500 was up by 6% in January alone. This sounds like a good thing, but we all know it’s not sustainable. We need a market correction occasionally to keep markets healthy and valuations in check.

Is this market correction typical?

Historically, market corrections (drawdowns of 10% or more) have occurred an average once every 357 days, essentially once per year. The average market correction lasts about 72 trading days. However, they have been happening in a more compressed time frame over the past decade with the advent of computerized trading. It is impossible to consistently predict or time these downturns, which is why we never go to cash.  Nevertheless, an investor should expect a 10-15% drawdown once per year. These corrections are not a time to panic since they are expected and baked into each client’s financial/investment plan. The great news is that 100% of all past corrections have been buying opportunities.

Yesterday, the Dow was down 4.6%, or 1,175 points. This was the Dow’s largest one-day point drop in history, but only the 108th worst percentage drop. The last time we had a 4.6% drawdown in a single day was in August 2011. Hopefully, that drop did not scare you out of the market because the Dow was only at 10,700 then. Yesterday it closed at 24,345—more than twice as high.

My favorite chart to put any market correction in perspective:

The chart below shows the total return for the year (gray bar) and the red number below shows the pull back that happened at some point during the year. The S&P 500 has had positive returns in 29 of the past 38 years despite an average intra-year drop of 13.8%. 1998 was a perfect example of a year that returned double digit gains (27%) but also had at least one double digit drawdown (-19%).

Each market drawdown shakes out some market timers and short-term investors who move their money out of the market. This is almost always followed by regret when the market inevitably rebounds, usually sooner than people expect.

Why is a market correction a good thing?

I think of market corrections as being like getting a haircut. Even if you want to grow your hair long, you need to get the split ends trimmed occasionally. The market attracts speculators and momentum players who distort prices and volatility after periods of consistently good performance. We saw this in the real estate market in 2003-2006. A healthy real estate market is one that is upward trending, but moves up in correlation to rising incomes, so that homes do not become unaffordable. When the housing market had too many good years in a row, it drew house flippers and people borrowing too much money to buy houses they couldn’t afford. We all know how that ended.

A healthy stock market is one that is upward trending but the rise is correlated corporate earnings. As you can see from the chart below (from JP Morgan’s Guide to the Markets, Jan 31, 2018), earnings have been doing well and are expected to continue to do well:

Final Thought:

I am not at all concerned about the recent market volatility. This is normal, and our portfolios are performing right in line with expectations. No one wants to give back the gains he or she made over the past few years, but sometimes you must take one step back to take two forward. Call or email if you would like to review your financial plan, income needs, risk tolerance, investment portfolio, etc.

My other final thought is…turn off the TV and go out and enjoy your life. The stock market will do what it is going to do. Have a great week.