The Importance of Context When Analyzing the Stock Market – Motley Fool

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The past six weeks have been exceptionally volatile for investors. The CBOE Volatility Index, which is viewed as a gauge of fear and uncertainty in the stock market, catapulted from about 11 to more than 50, a nine-year high, in a matter of seven trading days between late January and early February. Over this time, the stock market sank to its first correction — i.e., a 10% loss from its recent highs — in two full years. In the span of a week, the Dow Jones Industrial Average (DJINDICES: ^DJI), the world’s most iconic stock index, registered on some of the biggest single-day point declines Wall Street has ever seen, including a 1,175-point, 1,033-point, and 666-point drop.

Why the decline? Though there are really a confluence of factors at play, it appears to be a combination of rising bond yields that could lure some investors out of riskier stock investments and into bonds; the expectation that higher interest rates will weigh on lending, consumer mortgages, and credit card debt; and simple profit-taking.

A man reading the financial section of the newspaper.

Image source: Getty Images.

Putting stock market moves into the proper context

Yet if we were to take a step back and examine the Dow Jones’ “tumultuous” February, we’d see it really wasn’t out of the ordinary whatsoever. Sure, investors have been somewhat spoiled in recent years by a lack of volatility, but that doesn’t mean what we’ve witnessed in recent weeks is any cause for alarm. The truth of the matter is that when analyzing the stock market, investors have to take the bigger picture into account. Focusing too much on the short-term may otherwise lead to rash decision-making.

For example, consider the actual stock market correction itself. The swiftness of the nosedive in equities may have caught some investors off-guard, but both the timing of the correction, and its swiftness are nothing out of the ordinary.

According to data from Yardeni Research, the broad-based S&P 500 (SNPINDEX: ^GSPC) has undergone 36 corrections of at least 10%, when rounded to the nearest whole number, since 1950. That’s nearly one correction every two years. We know the stock market doesn’t adhere to averages, but we do know, based on this data, that stock market corrections are actually quite common. The 10% decline the market experienced over a span of just a few weeks just happened to be right on cue, as our last correction occurred during the first quarter of 2016.

In addition, the swiftness of the decline was perfectly normal as well. Adding up all of the trading days the S&P 500 has spent in correction since 1950 would yield a figure that’s just above 6,600 days. By comparison, the S&P 500 has spent the other 18,000-plus trading days in bull market rally mode. In other words, even though corrections are normal and healthy, they tend to occur quickly and give way to significantly longer-lasting bull market rallies.

Think in terms of percentages, not points

Investors also need to consider stock market moves in the context of percentages, not points. You see, the major stock indexes, like the Dow and S&P 500, have a tendency to increase in value over time. That’s because they’re packed with high-quality businesses that tend to grow their sales and profits over the long run, thus commanding a higher market value. As time passes and indexes increase in point value, bigger daily or weekly fluctuations can cause investors to grow wide-eyed. However, on a percentage basis, these moves are nothing out of the ordinary.

A table showing the Dow's 20 largest point gains and decline of all time.

Data sources: Wikipedia, The Wall Street Journal. Table by author. Yellow highlights signify Dow Jones percentage moves that are among the 20 biggest single-day gains or declines of all time.

That table that lists the Dow’s 20 biggest single-day point gains, as well as its 20 largest single-day point declines, complete with the corresponding percentage move as well.

Over the past couple of weeks, the Dow has rattled off three of its biggest single-day point gains of all-time, as well as three of its biggest single-day losses. However, you’ll note from the yellow highlighting of select percentages above that only two of the 20 largest single-day gains, and just seven of the 20 biggest single-day losses, are also among its 20 top percentage gains or declines of all time. In fact, the 440.53 points the Dow gained this past Friday, which is good enough for its 13th-best single-day performance in history, only amounted to a 1.77% gain. To make the top 20 gains of all-time, the Dow would have to register a 7.12% increase, or around 1,800 points in a single session, based on its current value. 

A long-term chart of the Dow with Black Monday highlighted in yellow.

Image source: YCharts. Yellow highlight in chart represents Black Monday in October 1987.

Furthermore, if we examine a long-term chart of the Dow, you’ll note that Black Monday (highlighted in yellow), the 508-point, 22.6% shellacking that the stock market took back in 1987, looks like a hardly noticeable blip a little over 30 years later.

Put plainly, when things are put into the proper context, it means not having to worry about volatility or corrections.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.