The recent market weakness reminds us that short-term market declines can be nerve-racking and emotionally exhausting for many investors. However, small short-term declines are a sign of a healthy market, and most declines seldom lead to a full-fledged bear market. In fact, 80% of the time, stock market corrections are limited to 10-12%. Moreover, healthy bull markets often experience 3-4 market corrections of this magnitude per year. Strangely, since the COVID recovery began, market declines have been much more shallow and swift! As we have mentioned in previous correspondence, it is important that investors prepare for more normal market volatility and corrections.
Imagining why it is healthy to watch the value of your portfolio decline can be puzzling, so we like to draw comparisons from other parts of life. For example, catching the common cold is an essential part of immune-response building for young children. Taking a rest day is vital for athletes interested in the longevity of their fitness. The stock market is a function of supply and demand, and it is constantly looking for equilibrium – but this function must be supported by real growth, not simply investor enthusiasm. Corrections help investors "cool off" when they have gotten too enthusiastic. Normal volatility is part of the market's equilibrium searching process. Historically, the worst recessions occur when the market has not found this equilibrium for an extended period – we saw this in 2001 and again in 2008.
Over the past year, we have seen historic price appreciation. Since the beginning of the year, the S&P 500 and the Nasdaq Composite are up 14% and 13%, respectively. In addition, the price to earnings ratio of the overall market as measured by the MSCI Global Stock or S&P 500 index is approximately 19 and 22 respectively. Although not at overvalued levels, it is another sign of the market's strength in recent quarters. This data sets the stage for a normal, healthy correction in the second half of 2021 and would make price-earnings ratios more attractive. While we are optimistic in the long term, a correction in the second half of 2021 would not surprise us. The recent ascent has been at record speed, and while we feel that the economy is healing quickly, we are still looking at the next half of the year cautiously.
Market corrections can also be healthy by distinguishing the "smart money" from the crowd. Smart money trades on data, while many others trade on emotions. As Warren Buffet famously said, "If you cannot control your emotions, you cannot control your money." Statistics show that the average investor is most confident at peaks, and least confident during dips when they should really be the opposite. We urge everyone to remember this quote during market volatility.
If the current market weakness develops into a more normal market correction, we will examine it closely to determine its direction, cause, and longevity. If we lose a few stocks due to stop losses, we are always prepared to reallocate capital as needed and take advantage of any buying opportunities in alternative sectors. Please keep in mind that our Active Risk Management process is aimed to mitigate catastrophic losses caused by recessions/bear markets - not to prevent normal volatility during market corrections. Of course, our Active Risk Management is in place should we find ourselves beyond a normal correction.
We hope you find this brief research piece helpful. Our open communication with clients, especially through volatile times, is a critical part of what we consider "success."
If you have experienced any changes in your finances or have a question regarding your portfolio please feel free to reach out.