If you've been tuned into the market's ugly recent slide, it's probably hard to believe that just three weeks ago the market was setting new all-time highs. This downturn has been sudden and painful, but isn't particularly noteworthy — yet. The unfortunate reality of investing in stocks is that these types of market spasms are fairly common. If you want the stock market's long-term returns, you have to deal with its volatility.
Yesterday's big drop was the 20th time the S&P 500 has fallen -3% or more in a single day since the last bear market ended in 2009. So it's been par for the course for the market to do this a couple times each year during this extended bull market we've otherwise enjoyed. For those interested in longer-term history, Bespoke Investment Group notes yesterday was the 98th single-day drop of -3% or more since 1952 (when the NYSE switched from a 6-day week to a 5-day week). So while these types of drops aren't exactly routine, neither are they so unusual that we should be concerned.
October has long had a reputation for stock market volatility, so perhaps it shouldn't be surprising that the market's recent lack of volatility would come to an end this month. The market hadn't closed with a move of at least 1%, either up or down, since late June. Until the past week or so, we'd had an unusually calm market.
Despite the tough start to October, it's important to keep the recent losses in perspective. The S&P 500 is off about -6% from its recent highs. Other parts of the market have been hit harder: the small-company Russell 2000 index is down almost 9% during that time. (Both of these were calculated during the day Thursday and may have changed by the time you read this.)
But again, the market indexes aren't even into official "correction" territory at this point (which is normally defined as a drop of at least -10% from a prior high). That doesn't make these losses less painful, but it does mean the panic meter should still be off at this point. Looking just at the history of the current 9-year bull market, we've had declines greater than this in 2010, 2011, 2015, 2016, and earlier this year. That's five prior corrections in nine years, without any of them ending the bull market's march forward.
Eventually, a downturn like this will turn into a correction, which will turn into a bear market. It could even be this one, but at this point, there's no particular reason to think that will be the case.
The immediate cause of the recent downturn has been rapidly increasing interest rates — and the concern that they may not be done surging. As Wolf Richter points out at his blog, the 10-year Treasury yield has had two prior spikes of roughly 1% since rates started rising two years ago, with some back-filling in between. The concern now is that, with certain key technical lines having been crossed recently, a third surge may be at hand.
While these rates are still low historically, they're moving out of the range of being "so low" that they've been stuck in for the past decade. That's making equity investors nervous, since part of the rationale for high stock prices all along has been historically low interest rates. Add to that mix the fact that leverage was high going into this (and losses are worse when investors are leveraged, just as gains are larger with leverage when the market moves higher), which is undoubtedly causing additional selling as these investors sell to cut losses. And, of course, it seems every big market move gets amplified these days, likely due to computer/program trading that grabs the current trend and pushes it even further.
Can't protect against routine corrections, but...
As long-time SMI readers know, it's our position that trying to defend against routine market corrections is counter-productive. They simply happen too often and are too quickly erased to make defensive measures worthwhile. However, if you're following SMI's DAA and/or Upgrading (2.0) strategies, you also know that there are defensive protocols built into those strategies which will trigger if this downturn turns into something more significant. These protocols are intentionally designed to not kick in during the first short stretch of losses, not because we don't care about the first -10%, but because of the tradeoffs involved in protecting that first -10%. So apart from DAA being allocated one-third in cash going into this downturn (which we're grateful for), we haven't played much defense yet. But again, that will change if this downturn has legs.
Thankfully, it's exceedingly rare that bear markets just whip up out of the blue and take the market from all-time highs to deep losses in a matter of weeks. We've documented many times how the normal pattern is for the market to form the type of "rolling top" that makes investors think they are still in a bull market many months after the market has indeed peaked. This was the case in 2008, when the high was reached in October 2007 but the market didn't start falling in earnest until nearly a year later, as well as in 2000, when the market peaked in March, nearly reclaimed that level in August, and didn't deteriorate dramatically until the following February.
With that in mind, at this point it seems just as likely that the market will bounce back after the midterm election uncertainty is over as follow-through into a bear market from here. But as we've been writing over and over this year, with market conditions as they are, we have to be prepared — both mentally and portfolio-wise — for the possibility of a bear market. So we certainly can't discount the possibility of that. The speed and ferocity of this decline is more in line with past corrections than bear markets, but that's certainly not foolproof.
At this point, it's important to recognize that it's impossible to know which of these paths we're on. Each of the prior five corrections we've suffered through during this current bull market has felt just as scary as this — or worse. That's why we fly by our instrument panel rather than our emotions. We have objective, mechanical criteria to evaluate market conditions — built right into our strategies — so we don't have to be overly stressed over what to do now. If this is a short-term issue, as most of these downturns and corrections turn out to be, it will soon be over. If it's not and this actually is something more severe, our systems will guide us to the appropriate moves at the appropriate times.