How Bad Could It Get?

The stock market has had a rough start to the year. Most major indices are either in “correction” territory or close, but before we try to make sense of what all this means, let’s first analyze the history of corrections and attempt to pinpoint their root cause.

A “correction” is defined as a drop of 10% or more in the value of an index. The table below provides some context around the frequency and severity of corrections in the S&P 500 since 1942. While these numbers may appear frightening to some, consider the following facts:

1. Corrections Happen: Pullbacks greater than 10% are not only common, but they’re almost an annual event. 
2. They Don’t Last: Paper losses lasted for a few months on average.
3. Big Drops are Rare: The S&P 500 has not fallen more than 20% all that often. Furthermore, the index has only seen six drops greater than 30% since 1950, or roughly once every 12 years¹. 

Since corrections do happen, let’s dissect a stock price using the formula below to better understand their root cause.

Stock Price = Earnings x Valuation

Earnings are fueled by economic growth, competitive positioning, management experience, and other fundamentals that change slowly over time. Sudden moves in stock prices rarely depict abrupt changes in these. For example, if the stock market drops 10% in a month, it is highly unlikely that the average company’s future profitability could change that fast. What can change is how investors perceive the value of the stock market. 

Think back to the housing market in 2008, when it seemed as if the value of properties dropped overnight. This did not happen because homeowners suddenly realized that all the concrete used to build the foundation of their homes was poured incorrectly. Instead, buyers left the market because they no longer wanted to buy or could qualify to buy a house. 

The same applies to stock prices. Corrections almost always occur because of a sentiment shift rather than any fundamental issue because an economy simply cannot move fast enough to drive that much of a change the stock market. 

That’s also why corrections are common but usually don’t last long. Sentiment is fickle, and the focus eventually shifts back to the fundamentals as long as they remain intact.

Who Knows?

When the stock market moves sharply, fickle or not, people want to know why. Market pundits are quick to comment because those who can provide insight are regarded as having a “feel for the market.”

But neither brokers nor stock exchanges require us to explain why we buy or sell stocks. In fact, asset managers often go out of their way to maintain anonymity by trading in “dark pools,” which are special venues where activity is kept secret.

Instead, market commentary comes from a mix of sources that are often unreliable, such as large trading desks on Wall Street. These traders move millions of shares every day and are in constant communication with large asset managers making buy/sell decisions. The problem is that since most trading is electronic these days, their insight explains a fraction of the overall volume. 

Said another way, market commentary is rarely more than an educated guess. That’s not to say it’s inherently bad or useless, but rather to just take it with a grain of salt. 

The Bottom Line

The chart below shows that an investment of $10,000 in the S&P 500 on January 1st 2008, would have grown to over $43,303 by December 31, 2021. More than tripling your money with an average annual total return of 11% is not too shabby, but this chart also reminds us of what you would have had to stomach along the way.

It’s not just two of the worst recessions in modern history either. There is a consistency in the pain inflicted on investors, and it’s relentless. These events happen so frequently that it’s hard to remember them all. But there’s another reason why we don’t remember – they are usually forgettable.

Case in point. Go back to March last year when the NASDAQ 100 index fell over 10%. How many investors remember this? When was the last time pundits on television discussed this “bloodbath”? Or has it become a distant memory since the index ended 2021 up over 26%²?

There is also no reason to expect owning stocks to get any easier anytime soon. This pain is the price you pay to position yourself for the potential returns offered by stocks. The trick to coping with this discomfort is to change your perception on what volatility truly represents.

Think about it this way. Volatility is a measure of the short-term movements in stock prices. Since the daily ups and downs are driven by emotional reactions to events like the ones in the chart above, then by association, volatility is a measure of emotion. Hence, when the stock market gets more volatile, it’s just getting more emotional. Sentiment is rarely strong enough to derail a $22 trillion economy, so most market temper tantrums aren’t a sign of any real risk. 

That’s why I have absolutely no idea if this volatility will get worse, but I also don’t care too much. Timing stuff like this is pointless because it’s (1) unpredictable and (2) usually temporary. But don’t take my word for it. Peter Lynch, one of the greatest investors of all time, said it best: 

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” 

The bottom line is that the real danger in the stock market right now is not volatility but rather how volatility causes investors to react. Keep emotions in check and focus on what drives stock prices over the long run.

Sincerely, 

Brian Malizia, President

Mike Sorrentino, CFA

Sources

1. https://www.capitalgroup.com/individual/planning/market-fluctuations/past-market-declines.html  

2. Bloomberg, as of 1/25/2022

Disclosures 

This newsletter/commentary should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.