After 2013, many investors had forgotten that stocks could actually decline. While 2013 was a banner year for stocks, it was very much a historical abnormality in which equities seemed to ignore bad news (including a federal government shutdown) and rallied most of the year. Now that we're in 2014, investors have been reminded that market corrections do happen and we wanted to take the opportunity to discuss the recent pullback and what may come next.
Market Corrections are Normal
From its peak in January, to a trough in the first days of February, the S&P 500 index declined nearly 6 percent.[1] At the same time, other asset classes that performed poorly in 2013, such as bonds and gold, advanced. Some traders were caught off guard by this reversal, but they shouldn't have been because corrections of 6 percent are not atypical.
Since 1928, the S&P 500 has generally experienced between three and four corrections of more than 5 percent each year; the recent pullback was the 19th decline of 5 percent or more in the current bull market.[2] Declines of 10 percent or more are rarer, but are still seen nearly every 1� years, and "bear market" corrections of 20 percent or more are seen roughly once every three or four years.[3] Obviously, these are all averages and the performance of any single year can deviate significantly from historical norms.
A 2014 Correction Was Widely Predicted
After the blistering pace of growth exhibited by stocks in 2013, analysts all but knew that a correction had to come. Normally, as markets go up, some sectors and industries become overvalued, but there are still plenty of other areas that are still undervalued or fairly valued given the economic and market conditions. However, once equities get near market tops, traders become hard-pressed to find any upside, and savvy investors don't want to add any new money to push the market higher, causing a pullback. How far equities decline depends on a lot of factors, including investor sentiment, corporate earnings, economic data, and growth prospects for the near future. While a currency crisis in emerging markets triggered the most recent selloff, domestic indicators and earnings reports show that the U.S. economy is still chugging along just fine.
We can look back at past market declines for hints of what we might expect going forward if markets follow historical trends. Since 2009, pullbacks of 5 percent or more have lasted an average of about a month, peak to trough, meaning that the recent downturn (which lasted 20 days) may not be completely over.[4] As of February 14, domestic stocks have bounced back. The S&P 500 index has regained nearly all of its lost ground, gaining 5.6 percent since early February as investors have used the correction as an opportunity to "buy the dip."[5]
Market volatility is still high and it's unclear how emerging market issues may affect market performance in the coming weeks. That said, the U.S. economy is doing very well and some analysts expect GDP growth to accelerate to 2.8 percent in 2014 and 3.1 percent in 2015.[6] While we can't predict the future, we have high hopes for stocks in 2014.
Conclusions
Though market corrections are rarely welcome, they are a natural part of the overall business cycle and it's important to take them in stride. Declines also provide an environment to test your risk tolerance and ensure that your financial strategies and asset allocations are aligned with your long-term objectives and appetite for risk.
As professional investors, we've learned to seek out the opportunities in market corrections and volatility. Declines often create openings for tactical investing and allow us to invest in high quality companies at attractive prices. While we can't use the past to predict the future, history tells us that having the patience to sit out brief rough patches often benefits our clients in the long run.
We hope that you have found this information educational and reassuring. If you have any questions about market corrections or are concerned about how the recent pullback may have affected your portfolio, please give us a call; we're always happy to speak with you.
Warmest Regards,
