Is a Correction Coming?

The most recent “correction” in the S&P 500 ended on February 11, 2016.  A correction is defined as a decrease of 10% or more, and slides of this magnitude in the major market indices have occurred about once a year on average.  That makes the current market run of 412 days appear a bit long-in-the-tooth by historical standards, but not dramatically so.  So should we be expecting an imminent correction simply because the current rally is longer than the historical average?

Not necessarily.  The first point to stress is that market pull-backs are absolutely normal, and indeed they can be healthy for longer-term market fundamentals.  Corrections allow time for the market to consolidate its gains while also providing an opportunity for price-sensitive investors to establish positions at more attractive levels.   From a Financial Times article by John Authers: “Markets rarely move up in a straight line. As they are driven by human emotions, they tend to overshoot, in both directions. Bring share prices down by 10 per cent, and prices are more realistic, and new investors are more comfortable about entering the market. If the momentum continues without a correction, the danger is of a bubble that can only be corrected by a far sharper and more damaging fall.”

So corrections can be very constructive in limiting periodic investor euphoria – an emotion that generally doesn’t lead to positive investor outcomes.  Bursting bubbles can be very painful because they often fall well beyond fair value, forcing leveraged investors to sell out of positions simply because they lack adequate collateral.  Finally, and perhaps most importantly at our current time, occasional corrections might limit the pace at which the Fed normalizes interest rates.  Given how dependent our economy and markets have become on low interest rates, this is not a minor factor.

Where do we currently stand?  Are the odds of a correction increasing?  After the aforementioned selloff at the beginning of 2016, markets have continued their upward trajectory without any of the major market averages slipping into correction territory. In fact, the S&P 500 is up a huge 29% from the correction low on February 11, 2016.  But while major indices like the S&P 500 have not pulled back enough to be deemed a “correction”, six of the eleven S&P 500 industry sectors have indeed experienced declines of 10%+ since then. Leading into the November election, the Health Care, Consumer Staples, Real Estate, Utilities and Telecom sectors each suffered significant declines that weighed on the overall index but which were mostly offset by gains in other sectors of the index. Since the election, energy has been the worst performing sector and the only one to experience a correction. The chart below illustrates the S&P 500’s returns since the market lows of February, 2016. The red arrows represent the time frames over which that particular sector dropped (from peak to trough).

*Data obtained from Bloomberg

It is important to understand as a long-term investor that market corrections are inevitable, and unless you are a market-timing guru (we aren’t), they are also unpredictable. Market pundits will speculate about when pullbacks might occur, but changing one’s investment strategy based on short-term noise often proves costly. And while market corrections are never easy to digest as they are occurring, they should be viewed by long-term investors as an opportunity to establish or add to positions at better prices.  Warren Buffet often talks of the perverse psychology of many investors: they like stocks when they are expensive but hate them when they are cheap.  We agree with Warren.  Over the long term, market-wide corrections occur about once a year, and despite not experiencing one since early 2016, the downturns we have seen in six of the eleven sectors in the S&P 500 are an encouraging sign that “pauses that refresh” have indeed taken place.

We are constantly using market fluctuations, including corrections, to evaluate client positions.  As individual industry sectors swoon and opportunities present themselves, we will not hesitate to establish or add to positions.  Conversely, strength in individual sectors can often provide the opportunity to take some chips off the table.  Hopefully, the end result is a portfolio that will participate in times of market strength while also providing downside protection during times of market weakness.