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When Is the Correction Coming?
by Mitch Zacks, Senior Portfolio Manager





After finally breaking through the psychologically important 1700 level at the end of July, the S&P 500 is trading ever so slightly off record highs. Although earnings are growing, the market is getting more expensive and top-line revenue growth remains weak. Therefore, the question that seems to be on everyone’s mind is: When is the correction coming?

The answer to that question, as unsatisfactory as it may be, is that no one in the history of the stock market has ever been able to consistently and accurately predict the exact time a stock market correction will start and end. If someone tells you otherwise, it should raise a large red flag in your head. However, one thing we do know is corrections happen on average once a year in the Dow. Since 1926, we have seen 20 corrections for the S&P 500, even in years when the market produces great returns.

A correction is defined as a short, steep drop in the market of approximately 10-20%, followed by a quick bounce back to pre-correction levels, creating a V shape if you looked at it on a graph. A bear market on the other hand comes on slow with multiple tops, great optimism regarding stocks and then a large crash at the end of it. Historically bear markets generally last 18-24 months, while corrections last just two to four months. 

The last correction we saw, although not quite 10% was over a year ago when the S&P 500 declined 9% from the beginning of May to the beginning of June of 2012. By August 15th 2012, the market was back to pre-correction levels, and has been trending up ever since then.

Corrections are usually surrounded by stories that seem like they could unravel the global economy. However, with a little bit of hindsight, we find it wasn’t such a big deal after all.

Some recent examples of these non-stories include the theory that the consumer is tapped out, the Chinese economy stumbling, Washington politics producing self-inflicted wounds, and too much or too little stimulus. Then of course there is the big one, which investors still fret about even though the story has been around for three years now, Europe. People fear a Eurozone nation will default, leading to a contagion that will adversely affect the global economy, global markets and ultimately their portfolios. However, as we have seen time and time again, these issues typically are resolved and the market continues to gradually trend up.

The good news is that corrections are a normal and healthy part of a bull market. They instill a healthy amount of fear in the market. As long as there is fear, and positive economic news that goes largely ignored, the bull market should continue.

The bad news is too many investors will end up being whipsawed by the next correction. Investors who have been sitting on the sidelines with too much cash in their portfolio are watching this market rise and getting worried they are missing the boat. 

They have been putting that cash to work, which is one of many reasons we are seeing the market at all-time highs. The problem is they could be getting back into stocks just before a correction hits. These investors could see a sharp drop in stock prices coupled with a scary, media-driven story and decide they need to get back out. Thus they will participate in the downside of what otherwise will likely end up being a year of nice returns for stocks. 

So what should an investor do knowing a correction is probably coming but has no idea when? First of all, they should ensure their portfolio is constructed to match the type of investor they are. 

A retired investor using their portfolio to supplement their income should have a well-constructed portfolio that fits their needs, limiting their exposure to equities before a correction ever hits. 

An investor who has been sitting on a pile of cash earning nothing might want to start thinking about getting back in slowly. As long as the fundamentals are strong and there is still pessimism surrounding stocks, there is probably more bull market ahead and more corrections as well. 

An aggressive investor whose portfolio is almost all stocks should do nothing. Trying to time a correction is a fool’s game and since they end as quickly as they begin, the best decision is to do nothing. 

An investor who wants to be aggressive but can’t stomach a 10% drop in a short amount of time should have securities in the portfolio that will limit volatility, such as bonds. As aggressive as you may want to be, watching the value of your portfolio drop by 10-15% in a month and taking no action just isn’t possible for some investors. The key is to know yourself and what you would really do in that situation.

Corrections happen. They are an unpleasant yet healthy part of investing. The key to getting through them is to have a portfolio suited to your needs and risk tolerance.

There is very little chance the S&P 500 will go up another twenty percent over the next five months. The majority of the gains for the year have most likely already occurred. Instead, I am looking for a more moderate 4.5% growth in the S&P 500 over the remainder of the year with some volatility. I do however remain bullish for the market, and believe that individuals investing now and holding over the next ten years will effectively double their money.

Have conviction in your investing. If you don’t have conviction or the experience needed to navigate financial markets, hire someone who does. The worst thing an investor can do is jump in and out of stocks at the slightest dip or rise. This will only lead to poor returns and regret.