Corrections Are Not Predictable
The History of Corrections
A correction in equity prices is defined as a 10% – 20% decline, and they are generally considered to be healthy stages in a rising market because stocks often get ahead of themselves fueled on excessive investor enthusiasm. These “cooling off” periods allow the broader market to reset to a more appropriate level, given current economic growth.
The prevailing belief across most media outlets and market pundits is that a correction in equity prices is looming simply because we have not experienced one in over two years. These parties use history as a guide to show that equity markets usually see a correction once every 18 months. However, the Investment Committee strongly believes that the data do not support this notion.
We conducted research this week to dig deeper into the frequency of corrections using data from Dow Jones, Morningstar, and Bloomberg. Here are three interesting conclusions:
NOTE: The term “secular” refers to a time period of a decade or longer. Secular bull/bear markets come and go as part of the broader economic cycle, and the last secular bull market ended 15 years ago with the dot-com crash.
The chart below is an extension of the third conclusion above and shows that during the last secular bull market, the S&P 500 went close to eight years without a correction (way longer than the prevailing belief that one must happen every 18 months).
The red lines on the left indicate the first correction in our time series. The next correction did not occur until 1998, due to the currency crisis in Asia that took the S&P 500 down almost 20%. Also notice that just as we have seen a few pullbacks over the past two years, the 1990s experienced similar activity with a few 5% – 10% drops along the way. This slow and steady move up is indicative of a secular bull market, where equity prices rise over a period of a decade or more.
The Investment Committee strongly believes that we are in the early innings of a new secular bull market, and we anticipate a similar path up in equity prices over the coming years. However, since we have not seen this pattern in equity prices for close to twenty years, investors have become accustomed to seeing corrections far more frequently.
Simply put, there is no historical precedence to support the notion that a correction is looming right now for the sole reason that we have not experienced one in a while.
Implications for Investors
Those who believe that a correction is right around the corner have recently pointed to the spike in volatility over the past three weeks as yet another potential catalyst.
Most of this panic-induced selling has come from traders worried over geopolitical issues and the potential for interest rates to rise sooner than expected. As strange as it may seem, the Investment Committee actually welcomes this rise in volatility with open arms.
Volatility allows investors to build positions as short-term traders sell due to fears that are irrelevant to long-term holders. For example, geopolitical issues are almost always buying opportunities because these events are never strong enough to derail an economy (even the terrorist attacks during September 11, 2001, did not keep equities down for an extended period of time).
Furthermore, rising interest rates may be bad for traders that attempt to profit from short-term moves in equities, but they are great for investors because rising rates during periods of controlled inflation indicate that our economy continues to get stronger at a healthy pace.
There is no question that risks exist in our economy, and any one of these risks could spark a correction if fear ultimately overpowers logic. However, given that we see a very low chance of a recession in the coming years and equity valuations are not excessive, it may also be some time until we see the next correction.
NOTE: Last week’s Thought of the Week discussed why timing a correction as an entry point is highly ineffective because they are impossible to predict. Those who have been waiting to buy at a lower price have been forced to watch the S&P 500 do nothing but go up close to 40% since the last correction.
The bottom line is that the Investment Committee is not making a call that a correction will or will not happen in the coming months because there are no crystal balls in this business. Rather, we present this data to our investors to make the point that a correction does not have to happen simply because one has not happened in a while.
We remain focused on the strengthening fundamentals in our economy and seeking investments in companies that have the potential to consistently grow their earnings.
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private Capital is an SEC Registered Investment Adviser.
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