Content provided by Kostya Etus, CFA, Portfolio Manager
To quote someone that I’ve learned quite a bit from, you and I are a perfectly natural, normal thing. Perfectly natural. — Jim Levenstein, American Wedding (2003)
We knew the historically low levels of volatility couldn’t last forever. It wasn’t normal and bound to end. We experienced one of the longest market stretches on record without a 5% drop (400 days to be exact). Sometimes the freight train just needs to blow off a bit of steam. It’s a perfectly natural, normal thing.
How normal is a 5% correction? Very normal. The table below from Ned Davis Research shows a 5% drop in the S&P 500 has occurred, on average, three times per year since 1928.
So what’s all the fuss about? Since we have been in one of the longest and strongest bull markets, which started after the financial crisis of 2008, investors have become complacent, and they have forgotten volatility is natural within markets. It also didn’t help that 2017 skipped 5% drops altogether. Now, hopefully, things will get back to “normal” and there will be healthier levels of volatility — moderate volatility is better than extremely low volatility that eventually blows up.
Additionally, note the table shows a 10% correction happens about once a year, a 15% about every two years, and a 20% about every three years. But that does not mean they happen consecutively. There is only a 32% chance that a 5% dip turns into a 10% correction. Likewise, a 10% correction turns into 15% less than half the time (45%). Translation: A 5% correction does not typically signal a bull market peak, and there could be plenty more gains to be made.
Lastly, note the bottom row shows returns-to-date from the last occurrence. Let’s remember markets are cyclical, but long-term returns are more than a coin flip. Each downturn is typically followed by a recovery and new market highs. Investors would not want to miss out on those gains by sitting on the sidelines due to loss-aversion bias (feeling the fear of losing money more than the joy of gains). Thus, investors should stay balanced, diversified, and invested for the long run.