The Next Big Market Correction

Friday, June 16th, 2017

With the current bull market in its 8th year since the March, 2009 bottom, a week doesn’t go by without someone in the financial media trying to make a name for themselves by predicting the next big stock market correction.

Actually, if you tune into CNBC, you can find one of these predictions nearly every day!

Given all of this talk, it didn’t surprise me when I recently received this very important question from a new Relaxing Retirement member while reviewing their Retirement Blueprint™:

What is our strategy if we have another big market correction?”

That’s a great question. However, in order to arrive at an accurate answer, I suggested that they substitute the word “if” with “when”.

In other words, there is no point in discussing what we will do “if” we have a major correction. It’s only a matter of “when.”  

If history is any indicator of the future, then they will experience multiple bear market corrections over the course of their lives in addition to the typical, yet temporary annual setback.

While they didn’t love hearing this and responded with a bit of a nervous chuckle at first, they felt a lot better once I shared a few facts about historical market corrections before discussing our strategy.

Having a successful and relaxing investing experience for the remainder of their lives requires an unwavering awareness and acceptance of the nature of markets, volatility, and expected returns.

 Historical Market Corrections 

  • Using the S&P 500 Index as a market barometer, since 1980, the average annual “intra-year” peak-to-trough market drop averaged 14.1%. At some point in the beginning, middle, or end of a typical year, prices fell 14.1%.
  • To put dollars to that statistic using nice round numbers, if the equity portion of your Retirement Bucket™ is an even $1 million (you likely don’t have 100% in equities), that means that at some point during the average year, the value of your equities would have temporarily fallen to $859,000. As you’re about to discover, the key words there are “equity portion” and “temporarily”.
  • Less than 20% of market corrections turned into bear markets (a 20% peak-to-trough fall in prices)    
  • One out of every three bear market corrections has exceeded 40% (i.e. the price of the S&P 500 fell 49.1% during the Dot.com bubble in 2000-2002, and 56.4% during the housing crisis of 2007-2009)
  • Since 1945, there have been 14 bear markets with an average correction of 30%, i.e. one in every five years

While all of this sounded pretty bad, here is the “rest of the story” I shared:

  • In spite of the average annual intra-year correction of 14.1% from 1980 through 2016, annual returns were positive in 28 of those 37 years
  • In spite of all of the ugly bear markets over the last 71 years (which spans all or certainly the majority of your life) one dollar invested in 1945 grew to be worth two thousand and forty-four dollars in 2016. Or, for better perspective, $1,000 became $2,044,000. Yes, that’s $2 million.
  • Since 1945, the compound annual growth rate of the S&P 500 Index (with dividends reinvested) was 11.17%

   Corrections: Unique or Common?

 What all this data confirms is that market corrections (large and small) are extremely common. While not fun to experience if they are taken as a surprise, they are 100% normal, they are temporary, and they are simply a part of our lifelong investing experience.

However, in the heat of the next market correction when prices have fallen sharply for the fourth day in a row, this is NOT what you are going to hear from the dominant financial media.

In order to capture your attention so you continuously tune in, what you will definitely hear instead are the four most costly words in investing according to legendary investor John Templeton:

“This time is different!”

What you will hear from friends, co-workers, and the majority of Americans is some version of:

  • “Here we go again…I knew it was too good to be true”
  • “I can’t afford to suffer these losses”
  • “I can’t see it ever coming back in my lifetime”
  • “Everybody is selling…I’m getting out until things settle down”
  • “What do you think of gold?”
  • “What about guaranteed annuities?”

Dalbar Statistics

 There is a direct link between these interpretations and reactions, and the dismal returns experienced by the average investor. According to Dalbar, Inc.’s 2016 annual Quantitative Analysis of Investor Behavior, while the S&P 500 index returned 10.16% annually over the last 30 years, the average equity mutual fund investor earned only 3.98%. (Please read that again)

Now that is sad!

One of the biggest reasons for these devastating results is the inability of the average investor to rationally interpret and respond to common and normal market corrections. Instead of capturing market returns, their actions caused them to miss out on over 60% of market gains each year.

Principles

 In order to understand our recommended strategy when we experience a market correction, there are some principles I shared with these new members which are critical to understanding our strategy:

 

  1. Although the financial media preaches otherwise, markets are efficient. Each day, there are roughly 10 million traders for about 500 million shareholders, trading about 10 billion shares on almost 100 exchanges all over the world.

Given all of this activity, at any point in time, a stock’s price has taken into account all readily available information and thus should be considered to be a fair price. It’s highly unlikely that you or I know something that millions of investors worldwide don’t know.

  1. Every investment carries an expected return. The risk of an investment is quantified by the degree to which the returns of that investment deviate from the average return during specific periods of time.

Higher risk (or more volatile) investments carry a wider range of short-term outcomes but also carry higher long-term expected returns, compensating investors for withstanding short-term volatility. Higher expected returns are the reward for an investor’s willingness to accept this volatility.

In other words, risk or volatility is the source of returns and, therefore, should be embraced in appropriate and carefully calculated doses.

  1. All outstanding shares of stock in every company are owned by someone at every moment. For every share that is sold, there is a willing buyer at the other end of the transaction who agrees to pay the price at which you mutually agree to sell.

This dispels the popular “market selloff” headline we see so much as there is no such thing.

  1. Although it appears to be the solution during corrections, market timing, i.e. attempting to sell right before prices fall, and buying right before prices rise, has proven to be an impossible long-term investment strategy to execute successfully.

According to extensive research by Professor Kenneth French, you would have had to be precisely correct on the sell and buy points 74% of the time in order to equal returns earned by continuously holding shares through all market cycles. A survey of famous market timers revealed that only a handful were correct more than 50% of the time, and the best was still at only 66%.

Takeaway

One of the keys to having a successful and relaxing investing experience is to not enter the game believing that you won’t experience temporary loss. As I stated earlier, higher expected returns are the reward for an investor’s willingness to accept and withstand short-term volatility. The only way to capture much needed market returns is to be able to weather inevitable corrections.

As you have already witnessed, this is not what you will hear from the financial media because it’s not the “magic pill” everyone wants, i.e. equity returns while experiencing the volatility of T-bills. Because of their emotional response to corrections, what most experience instead is the returns of T-bills with the volatility of equities!

During the next market correction, like the one we experienced in the first six weeks of 2016 when prices fell 13.3% from their most recent peak, there are two responses you can choose to have:

  1. “I’ve lost 13% of my money. There’s no end in sight, and I’ll never get it back!” Or,
  2. “I’m experiencing a perfectly ordinary, unsurprising, and above all temporary correction that represents the average intra-year correction in market returns, and it will have no lasting effect on my long-term returns.”

My goal is to help you confidently choose response #2 so you can dramatically increase your odds of having the relaxing retirement you deserve.