The stock market is full of various terminologies, some of which make more sense than others. One particular title I have never really endeared myself to is the word “correction,” which has come to define a market decline of 10% or more.
My lack of appreciation for the term stems from the insinuation that the market was incorrect to begin with and therefore as an investor there was something wrong with your judgment in owning stocks before they “corrected” to lower prices.
That’s always sounded a little insulting to me, especially in light of the fact that historically speaking most corrections have turned out to be pretty good buying opportunities, leading one to surmise that the correctness of stock prices may well be in the eye of the beholder.
To be clear, history has weathered varying degrees of these so-called corrections, the worst of which have been full-blown market crashes evolving into bear markets. Such was the case in late October of 1929 when the Dow Jones Industrial Average plummeted 25% in two days, triggering margin calls on most investors who had bought their shares with borrowed funds.
While this was by no means the sole cause of the Great Depression that engulfed the decade to follow, it did play a major role and is widely recognized as its starting point. So as corrections go, this was about as bad as they come, as people of my grandparent’s generation were always quick to attest to.
Not all downturns are equal
Fears of this nature emerged during another market crash in 1987 when, also in late October of that year, the Dow dropped 22% in one day. The irony of that day’s carnage was the lack of any real future economic damage that ensued.
While many that day feared a global economic meltdown, there was not even a recession for another three years. In fact, when looking at a long-term stock chart, you can hardly even see the impact of the 1987 crash. So in other words, for everyone who merely took a deep breath that day and then kicked back a few hours later to watch the Redskins upset the Cowboys on Monday Night Football, all turned out just fine.
Since 1960 there have been 35 times in which the S&P 500® has declined by 8% or more, which means on average investors should expect such downside activity about once every 20 months or so, or to round it off, let’s say about every year and a half. Typically, it has proved beneficial to buy stocks, or at least continue owning them through these periods, provided the investor’s time horizon is more than a few years out (which it should probably always be when owning stocks anyway).
This certainly proved to be the case with our two most recent corrections in August of 2015 and January of 2016 when downward adjustments on the S&P reached 12% and 13% respectively. In both of these cases, the market fully recovered by mid-2016.
In terms of our two most recent prolonged bear markets – from July 2000 to October 2002 when the S&P dropped 49% and from April 2007 to March 2009 when it dropped 57% – those took longer, approximately five and six years respectively to recapture the losses. Bear in mind (pardon the pun) that in both of those instances there were deep systemic issues brewing beneath the market’s surface, namely the technology stock bubble of the late 1990s and the sub-prime mortgage induced financial crises of 2008. Regardless, in neither of these harrowing occasions did it pay to sell into the declines.
So where does this leave us today? As of the first week of June all three major indexes, the Dow Jones, S&P 500® and NASDAQ are all at or a stone’s throw away from record levels. Moreover the Dow and S&P are up more than double digits since last November, and NASDAQ is up more than 20% since then.
Given the strong acceleration in corporate earnings we are seeing this year along with the potential for some degree of favorable economic legislation out of Washington in the year ahead, we feel these moves are justified. However, it is also important to note, that the last so-called correction concluded 16 months ago, putting the market close to that year-and-a-half or so average we’ve seen over the past six decades.
So are we forecasting a correction? No. Could we be at risk of one occurring in the foreseeable future? Yes.
However, that is not the point. Investors buying stocks immediately following the 13% downside correction of mid-1959 to mid-1960 would have made more than 200 times their money since then, and that includes the 35 corrections of 8% or more along the way.
The key to judging the potential severity of any correction is the underlying market fundamentals and macroeconomic environment surrounding it. At the current time we are experiencing the strongest stock earnings growth we have seen in more than five years. We also believe the economy could be in a state of pent up demand that over the next year or so could result in higher levels of gross domestic product (GDP) growth than we have seen in several years. Unlike past eras, our economy could also benefit from higher inflation, and recent trends imply that could be coming as well. In the event we get any help out of Washington in terms of fiscal spending or tax reform, this should only prove additive.
So while history implies we could see a market correction in the not too distant future, the current day tells us it may present some buying opportunities if and when it shows up.
About the author
Tom Wald is responsible for overseeing the investment and mutual fund product development functions and sub-adviser selection process. He also actively publicizes Transamerica’s investment thought leadership and products to advisors, clients, and the media. Tom has more than 25 years of investment experience and has managed large mutual funds and sub-advised separate account portfolios. Tom holds a bachelor’s degree in political science from Tulane University and an MBA in finance from the Wharton School at the University of Pennsylvania. He has earned the right to use the Chartered Financial Analyst (CFA) designation. Tom Wald, CFA® Chief Investment Officer, Transamerica Asset Management, Inc.
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