Keel Point Insights

Market Correction Q & A

Headlines on Tuesday, February 6th shouted that the Dow had just experienced its largest point drop ever the day before. This careful choice of wording probably earned a few more page views for offending news organizations, but clearly was hyperbole compared to the large, but not historically large, percentage drop suffered by the Dow. Here is the reality for stock market investors – they will likely endure many more “largest point drop ever” days (based on today’s value of the Dow they need only be greater than 4% to qualify) to earn equity returns over their investing horizons. This is the reason equity returns are, on average, higher than all others – they compensate for the drops that may not recover for weeks, quarters, or years.

We know most investors understand this intuitively, but questions nonetheless swirl in violent reversal periods such as the recent 10% cumulative drop from January 26th to February 8th. We thought an examination of the historical record may help. What follows is a series of correction related questions with our data supported responses.

Are Drops Like this Normal?

Corrections, defined as at least a 10% market loss from a previous all-time high, are not only normal but frequent. Figure 1 gives the dates from all-time high to correction bottom for all periods that meet this definition since 1970 using data on the S&P 500 index of large US companies (a more representative index than the Dow). The bar indicates the depth of the loss in absolute terms. There were 19 such events in the data set which works out to 4 corrections a decade, or once every 2.5 years. The median loss was 13% during these events, but the handful of bubble bursts on the chart push the average loss to 20%.

We should make a few clarifying notes. First, some of these events deteriorated much further than 10%, and are thus more accurately described as bear markets (20%+ losses) or crises (Tech Wreck or Global Financial Crisis). Second, our definition requires a new market high for a new correction to develop. For instance, the S&P had a significant drop surrounding the Euro Crisis in 2011, but the market was still working back from the Global Financial Crisis, had not made a new high, and thus doesn’t show up on the graph. A definition that measured losses from, say the beginning of each calendar year, would show more frequent corrections. We used such a definition in our February 7th Market Update: average intra-year corrections drop about 14%. Last, the last correction listed is the current one; the others are set in stone, this one may or may not be over.

There are some other interesting points to make about this analysis. Over this long period, the S&P 500 spent 30% of days in correction territory. This reflects the frequency of these events, but also reminds how it can take some time to bounce back from a particularly bad drop. On the other hand, the market made 1,164 all-time highs since 1970, representing about 10% of closes. This is a useful reminder that the other ubiquitous headline – “Market Closes at New High” – is also not all that uncommon.

Markets make highs, markets correct. Amongst these extremes, it is helpful to keep this other fact in mind: since 1970 the S&P 500 has compounded capital at a 10.6% annual rate. This fact assumes nothing more than you invested a dollar in 1970 and had the fortitude to simply let it grow. It did not require any special prescience regarding taking profits or adding new capital. However, this doesn’t mean there wouldn’t have been a useful strategy along these lines, hence our next question.

Does a 10% Drop Predict Anything?

By definition, a correction is a period during which stocks are at least 10% cheaper than they used to be. A good question is whether 10% cheaper is enough to make a difference. Consider Table 1 on the next page. Here we show the S&P 500’s return one year and five years (annualized) after a correction first reached 10% below the previous market high. So, for example, the market peaked on 4/28/71 and reached correction territory on 11/11/71. A year from 11/11/71 the S&P had bounced back and returned 27.1%. Five years from 11/11/71 an investor had earned 5.2% annualized, a below average result. Note that we aren’t measuring from the bottom of a correction (i.e. the data presented in Figure 1). This would tell a different story but is not a reasonable consideration because you can’t know that you’ve hit a bottom until much later.

Can Corrections Be Avoided?

Of course, the answer here is not with any certainty and not in full, but there are methods to employ that can help on average. Swift corrections, most famously Black Monday, October 19, 1987 when the S&P dropped 20% in one day, are the most difficult. These can often happen for idiosyncratic reasons that are usually unique to each correction and thus hard to prepare for. We would include what happened most recently in this category.

It is most helpful if a correction is preceded by softening economic, survey, and market data. The 2007-09 crisis had some of these characteristics. Strategies, such as Keel Point’s in-house tactical strategy, can use this type of data to decide on a level of aggressiveness or defensiveness. If enough data indicates trouble prior to the correction, such strategies can act to defend downside.

The other helpful component of a correction is length. Trend following strategies use recent market performance to decide on the magnitude of a long or short market exposure. So long as recent trends persist (i.e. a correction lengthens) such a strategy can help mitigate as well. There is evidence that this persistence does happen on average. The enemy of these approaches is the whipsaw market which reverses just as positioning changes in the opposite direction.

While the conclusions we draw here are not headline-worthy, we hope they are reassuring. Market corrections are normal; they are a trade-off for potentially high long-run stock returns. Rather than allowing a correction to lead to second guessing, we seek to establish a risk-targeted investment strategy calibrated to each client’s level of comfort. In other words, a correction simply leads to a result within the expected distribution of returns rather than panic and a decision to abandon ship.

This material is distributed for informational purposes only.

The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this re-port are obtained from what we believe to be reliable sources including Eaton Vance and The Wall Street Journal, but their accuracy, completeness or reliability cannot be guaranteed. An index is an unmanaged weighted basket of securities generally representative of a certain market or asset class. An investment cannot be made directly in an index. Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. No conclusion should be drawn from any chart, graph or table that such illustration can, in and of itself, predict future outcomes. You may request a free copy of Keel Point’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.

Past performance is not an indication of future returns.

Securities offered through Keel Point Capital, LLC, Member FINRA and SIPC. Investment Advisory Services are offered by Keel Point, LLC an affiliate of Keel Point Capital. Keel Point does not give tax, accounting, regulatory, or legal advice to its clients.  The effectiveness of any of the strategies described will depend on your individual situation and on a number of complex factors.  You should consult with your other advisors on the tax, accounting, and legal implications of these proposed strategies before any strategy is implemented.