Postmortem of a Correction

Loathe as we are to give any thought to short-term returns, the recent market correction has been interesting.

The S&P 500 index peaked on January 26, before dropping approximately 2% over the next few trading sessions, and then dropping more precipitously during the week of February 5. On February 8, the market had declined by 10%, officially a “correction” (it has since recovered a portion of these losses).

How bad was it?

While never comfortable, market corrections are common, and the recent 10% market decline was not historically unusual.

Since 1949, there have been 34 double-digit drawdowns in the US stock market – about one every other year, on average. Over the same period, the average magnitude of a market correction has been 15%. Over a longer history, since 1900, the Dow Jones Industrial Average has declined by 10% or more about once per year, on average.

Even in the current post-2008 market cycle, the US stock market has declined by double digits five times. US stocks fell 16% in 2010 over fears of a double-dip recession, and they declined by nearly 20% in 2011 during the European debt crisis. 2015 and 2016 saw corrections of 12% and 14% after a global growth scare and fears of a hard landing of the Chinese economy.

What caused this correction?

Nobody knows for sure, but that hasn’t stopped everyone from having an opinion. One interesting thing about markets is that the return experience drives the narrative. Several narratives have emerged, each of which is plausible:

  1. Rising rates: Real interest rates on government bonds have been rising since early September. Higher interest rates make future cash flows worth less today, sending stock and bond prices lower.
  2. Inflation concerns: On February 2, the government’s non-farm payroll report showed signs of wage growth, which suggests higher inflation in the future. Higher expected inflation implies that the Federal Reserve, especially with a new Chair, will raise interest rates more quickly than had previously been anticipated.
  3. Mean reversion: The S&P 500 index rose by nearly 6% in the month of January. Because broad stock market averages don’t rise by 70% a year, something had to change.
  4. Human emotion: Market participants, being human, wanted an excuse to sell and take profits. A market drop of uncommon (in recent memory) magnitude provided the reason.
  5. Robots: High-frequency trading, algorithms, and risk parity strategies have been blamed by some observers, although there is not consensus on whether these strategies represent enough of the market to have caused the correction.
  6. Valuations: In January, the two-year Treasury bond yielded more than the S&P 500 did.
  7. Fiscal (over)stimulus: In the face of historically low unemployment and stable economic growth, the recent adopted corporate tax cuts and proposed federal infrastructure spending initially poured high octane fuel into the economic engine. Subsequent realization that burgeoning deficits and rising inflation could disrupt the economic engine sparked a sell-off.
  8. Optimism: It is said that “markets climb a wall of worry.” The tremendous market gains since March of 2009 came during a period when most of the news about, and public analysis of, the market was negative and discouraging. With the benefit of hindsight, we can look back and see that economic fundamentals were steadily improving over these past nine years, but in the moment, that steady growth was obscured by dramatic negative events and headlines. By the end of 2017, all the headlines had turned positive – a survey of small business optimism was the highest it had been since 1980, consumer confidence readings were their highest since the mid-1990s, US unemployment was lower than at any time since 1999, and even wage growth was finally appearing. By January 2018, the wall of worry had crumbled, and the stock market, having reached its summit, responded to the law of gravity.
  9. Random chance: The 10-day market return was well within a normal distribution of short-term returns, and a reminder that returns are compensation for bearing risk.

Or some combination of the above. In the end, nobody knows, and it doesn’t really matter. Markets experience corrections of similar magnitude in most years. Explanatory narratives always emerge after the fact, but they don’t change the fact that markets don’t necessarily need a reason to correct. Just as trees do not grow perfectly vertically, markets never rise without interruption. Corrections are a normal feature of markets.

Nowhere to hide

What is more interesting to us is how diversified portfolios held up in the market correction – which is to say, not very well.

From peak to trough (January 29 – February 8), markets saw the following returns:

Return-seeking assets

  • US large-cap stocks (S&P 500): -10.1%
  • International stocks (MSCI ACWI ex US IMI): -7.8%
  • US REITs (Wilshire US REIT): -9.1%
  • Commodities (Bloomberg Commodity): -4.1%

Risk-hedging assets

  • Intermediate-term high-quality bonds (Bloomberg Barclays Aggregate): -1.0%
  • Long-term high-quality bonds (Bloomberg Barclays US Gov’t/Credit Long): -3.2%
  • Trend following strategies (Credit Suisse Managed Futures): -8.9%
  • US Treasury Inflation-Protected Securities (Bloomberg Barclays US TIPS): -1.1%
  • US short-term TIPS (Bloomberg Barclays US TIPS 0-5 Years): -0.3%
  • US Cash (US T-Bill): 0.10%

This correction was unique in that diversification did not appear to help. Assets that traditionally have offset market declines, like long-term bonds and trend following strategies, suffered negative returns along with equities. Although correlations between assets typically rise in times of market stress, risk-hedging assets have often been exempt from this phenomenon. In this recent correction, they declined as well, because the scare that affected equities – concerns for higher inflation and real interest rates – is bad for both bonds and stocks. Even assets designed to protect against changes in inflation expectations – TIPS – declined, because one component of their return is that of a Treasury bond.

Onward, With Caution

In a sense, market corrections are a gift: they provide risk, without which there would be no return.

The correction is a reminder that the only market history worth paying attention to is its long-term history. Prior to this most recent correction, the S&P 500 had experienced 404 consecutive trading days without a 5% drawdown, the longest such streak since 1959. An evaluation of the market only since January of 2016 would suggest an environment of return without risk, against a backdrop of global economic stability and a very low volatility. Complacency is a risk to investment decision-making in this sort of environment.

Moreover, we believe that a long-term perspective is equally valuable when assessing the merits of diversification. While all data points are valuable, diversification cannot be judged by how it performs in any ten-day period.

Finally, as much as the world is driven by computers and machines, markets are still moved by human beings. Humans overreact to new information, become overly exuberant when prices rise, and unreasonably panic when prices decline. The rational response to this scenario is to maintain calm and discipline – to be more robotic. Disciplined portfolios, including periodic rebalancing strategies, take advantage of market corrections by buying at lower prices.

There is no return without risk. Until three weeks ago, this notion may have seemed passé. The recent market correction suggests that the laws of finance have not in fact been repealed. A proper long-term perspective suggests that market corrections like the one we just experienced are normal features of risky markets.

Steep declines are much more likely in shorter periods than longer periods. A 10% drawdown inside a calendar year is relatively common, but a 10% drawdown over several years is very unlikely. Whether a 10% market correction is consequential to an investor depends entirely on the investor’s investment horizon. For any true long-term investor, over time, market corrections fade into irrelevance as signal overwhelms noise and distributions of return narrow. For investors with shorter horizons, the correction is a reminder that stocks are less suitable components of a portfolio and should be approached with appropriate caution and portfolio sizing.

Further Reading