Why a Stock Market Correction May Rattle Investors – Investopedia

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Investors on Wall Street today, made complacent by low volatility and soaring indexes, are much more likely to overreact to a correction, according to Barron’s. While a correction, typically defined as a fall of at least 10% in the stock market, is a common event in most market cycles, it’s been over a year since the last pullback of just 5% or more. From its intraday high on June 23, 2016 (2,113.32) to its low on June 27, 2016 (1,991.68), the S&P 500 Index (SPX) retreated 5.8%, but regained its former level on July 8, 2016, per Yahoo! Finance data.

This is only the sixth time since 1950 that the S&P 500 has gone more than 12 months without a 5% decline. It also is the longest period of time since 1995 in which the S&P 500 has not fallen by 5% or more. These observations were shared with Barron’s by Ryan Detrick, senior market strategist at independent broker-dealer LPL Financial Holdings Inc. (LPLA). As for the rest of 2017, “The odds of going the entire year without a 5% correction are extremely slim,” Detrick told CNBC. His analysis reveals that dips of at least 5% have occurred in 91% of the years from 1950 through 2016.

Source: CNBC

The Last Correction

Using intraday highs and lows, the last full-fledged correction for the S&P 500 ran from December 29, 2015 (2,081.56) to February 11, 2016 (1,810.10), a drop of 13.0%, also per Yahoo! Finance. The rebound was quick, however: it took just over two months, until April 15, 2016, for the S&P 500 to reach the previous high once again.

Shareholder-owned mutual fund giant The Vanguard Group Inc. conducted a study of global market corrections and bear markets from January 1, 1980 through January 22, 2016. Using the MSCI All-Country World Index as their benchmark, they found 12 global corrections and 7 bear markets (declines of 20% or more) during this period. On average, the corrections lasted 87 days from peak to trough, the MSCI index fell 13.7% (excluding dividends), and recovery took 121 days. With global bear markets, the respective figures were 373 days, 33.7%, and 798 days, Vanguard found. With respect to the S&P 500, they found that it spent about 40% of the elapsed time from 1928 through 2015 either in a correction or in a bear market.

Bigger Avalanche Ahead?

A combination of easy money from central banks and regulatory initiatives such as Dodd-Frank have reduced the frequency of loss events in the markets, according to Brian Singer, head of the dynamic allocation strategies team at employee-owned investment banking and asset management firm William Blair & Co. LLC, as cited by Barron’s. Instead of making the financial system less risky, Singer sees the net effect of these initiatives as analogous to mountainside fences that prevent small snow slides, but which create bigger avalanches later. In particular, Singer believes that investors have not had to navigate a major market event since the European debt crisis in 2011, and this has left them unprepared to deal wisely with the next crisis, per Barron’s. (For more, see also: 1987 Stock Crash Can It Happen in 2017?)

Buy on the Dip?

Based on his analysis of history since 1950, Detrick told CNBC that, when the S&P 500 gains 8% or more in the first half of a year, 84% of the time it adds another 4% to 5% in the second half. Add in optimistic consensus earnings forecasts, and Detrick suggests that investors buy on the dip. Other observers aren’t so sure. “That dip may be a chasm,” as economist, investor and longtime financial columnist A. Gary Shilling once warned about this strategy. (For more, see also: Stocks: The “Buy On The Dip” Party May Be Over.)