It's amazing how quickly confidence can turn to fear in the investing arena, isn't it? It was less than three weeks ago that the market was at a new all-time high, yet a couple of bad weeks later, there's a distinct whiff of fear in the air.
Let's put the pullback in context. Through yesterday, the S&P 500 was down 5.8% from its high (the market closed within 0.02 S&P 500 points on Dec 31 and Jan 15, so the year-to-date returns are the same as the returns since the new high on Jan 15). Nothing to shake a stick at, that 5.8% drop. Or is it? According to Bespoke Investment Group, that drop is pretty pedestrian. They note this is the 19th pullback of at least 5% since this bull market began in March 2009. 19 of them! In fact, the average of those 19 instances was 8.2%, which indicates this pullback has been a bit milder than most.
That said, this bull market has been a bit unusual in that there have only been two 10%+ corrections in this nearly five-year bull market. That is unusual, as I pointed out two months ago when the market was rocketing ahead. That post pointed out that over the past 33 years, the market has averaged a 14.7% drop at some point during each calendar year. If you were too engrossed buying online Christmas presents when that post originally appeared, take a look at it now. (There's even a really cool graphic.) The point of that earlier post was to help prepare us for today by letting us know before-hand that these types of pullbacks are routine.
The fact that we haven't had a true 10%+ correction since 2011 basically means we've been spoiled. It's unusual for the stock market to go that long without correcting. This bull market has offered a number of speed bumps, but no gut-wrenching air pockets for over two years. What does all this mean in terms of what the market does next? Probably very little, despite all the pundits attempting to convince people of their varying interpretations. It doesn't feel to me like this pullback has created very much fear, but of course, what I feel about the markets doesn't have any bearing on your — or my — investing course. The fact that we're "overdue" statistically for a deeper correction doesn't mean one is necessarily coming, though it does mean we shouldn't be overly surprised (or concerned) if this pullback does deepen. The reality is unless you are playing a very short-term trading game (which we most definitely are not and don't recommend), there's really no effective way to prepare for and sidestep these routine pullbacks and corrections.
Stock market history tells us 10%+ corrections come along once every 12-18 months, which is too frequent to continually be taking defensive precautions. Add to that the fact that the market tends to snap back pretty rapidly after they occur and it's easy to conclude (correctly) that trying to anticipate and avoid corrections is a losing effort. You're better off acknowledging the historical fact that they happen regularly and steeling yourself to DO NOTHING during periods like we're in now. What about full-blown bear markets, when corrections extend into 20%+ losses? Even there, it's debatable whether trying to take protective measures is counterproductive or whether it's better to simply ride those out too.
We've written about our Bear Alert Indicator and suggested some steps that can help relieve the emotional pressure at these times, but it's not conclusive that applying those steps actually helps returns over the long term. That's more about emotional support — allowing relatively small, pre-determined actions that keep you from taking larger, more damaging steps otherwise. The one place where we do take full-scale countermeasures against larger losses is in our Dynamic Asset Allocation strategy.
DAA has risk reduction built right into it, so as stock conditions deteriorate, it shifts our allocations away from stocks and into more protective asset classes. This measured, objective approach to risk reduction (as well as re-establishing those more risky stock allocations after bear markets) has been very effective at managing downside risk. We think it's going to be very helpful in encouraging SMI readers to stick with their plans through downturns and corrections, knowing that it's constantly monitoring and standing ready to scale down our stock holdings if the data (rather than our emotions) is saying such a move is appropriate. So, for now, we wait and watch what the market will do next.
There's certainly historical reason to believe this pullback has further to go. There's also historical precedent to believe that even if it does, it really doesn't change the outlook much. If you're overly concerned about your portfolio these days, it might be worth considering if a more conservative investing approach would be appropriate for you. Reviewing DAA (and perhaps boosting your allocation to that strategy, if appropriate) might be a good place to start.