Sunday, May 17, 2015

prepare for a correction

35 months. That’s about how long it’s been since the market pulled back at least 10%, which is an eyebrow-raising stretch of time. Take a look at the market each year going back to 1980 and you’ll find that the S&P 500 has averaged an intra-year drop of a little over 14%. Yet, here we are approaching three full years of a largely uninterrupted climb.

Is history telling us the stock market is due for a correction?

Be Prepared, Not Concerned

I’d classify the market’s behavior as uncommon or maybe even a little curious, but certainly not “concerning.” There have been a few periods like this one where the market charged higher and went years before pausing to pullback somewhere in the 10 – 15% range. The mid-90’s were a good example, and the market even went about three years in the 2002 – 2007 bull market without dipping more than 10%. Corrections, by definition, follow no clear pattern, are unpredictable, and pretty much come and go as they please. To say that a correction is around the corner — on the basis that we haven’t had one in years — is just as likely to be wrong as it is right.

But, history tells us we should at least be prepared as we've experienced a sharp pullback each year from 2010 – 2012, with the market resuming its upward course after only a few months.

2010 – a sharp dip of around -16% from April to June, with the market ultimately finishing about 13% higher for the year.

2011 – roughly -19% correction from May to mid-August, with the market finishing flat on the year.

2012 – the market pulled back approximately 10% from April to June, but recovered to finish up about 13%.

2014 – a decline in the neighborhood of 7% over a month in the fall, with the market posting an 11% gain on the year.

Since 2012, the closest thing to a correction we’ve seen was last year when the market fell about 7%, but it was so light few people even remember it.

If we omit 2014 from the conversation (since it wasn’t a real correction), it appears that this bull market has had a preference for pulling back in the summer months. With summer approaching, you may start to hear pundits calling for the ‘overdue’ pause. Don’t get too stirred if you do. Remember, as I said before, corrections by nature are unpredictable and don’t announce their arrival, so anyone calling for one has little basis for which to do so.

3 Lessons to Remember About Corrections

1) Corrections are Short, Sharp, and Sometimes Scary – this makes them noticeable, and can cause many investors to wonder if a 10% decline will turn into a 30% bear market that lasts years. That means emotion can enter into the decision-making process, for which investors have to be careful. A sharp pullback is often times just a normal – even healthy – part of a bull market. The key is having confidence in your longer-term outlook for stocks.

2) Trying to Time a Correction is Risky – the corrections in 2010, 2011 and 2012 each lasted about 3-4 months which, in terms of most investor’s time horizons, is an extremely small window of time. Remember too that many investors will sell after stocks have already fallen 10%, when fear sets in. That’s usually around the time when the market swiftly recovers, which can adversely impact that investor’s long-term returns – in addition to potentially racking up transaction costs.

3) Corrections, by Definition, Exist in Bull Markets – this may seem like I’m stating the obvious, but if there’s one thing we actually know about corrections it’s that they are going to happen. We just don’t know when and for how long. In many cases, simply acknowledging that corrections “come with the territory” of equity investing will help you apply patience and a steady hand when they do arrive.

Bottom Line for Investors

My outlook for stocks remains positive for the year, meaning that if we were to see a few months of downside volatility I think it would just be temporary — a correction. That is not to say I think a pullback will happen this summer or even this year. There is simply no way to know that. I would just encourage investors to think about the medium to longer term trajectory of stocks if/when some bumpiness hits, especially given the fact we haven’t seen a real correction in three years. It might not feel so familiar given the recent strong performance of the market, but being unfamiliar doesn’t make it unprecedented.

So as you consider a possible market correction, it may also be a great time to re-examine and optimize your portfolio choices to prepare for any upcoming surprises.

-- by Mitch Zacks, Market Insights, Zacks Investment Management

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