As mentioned in my Q2 Market Review piece, this market has been quiet…too quiet. Historically, the stock market averages 3 pullbacks of 5% per year with one of those going on to become a 10% correction. So when was the last time markets pulled back 5%. Remember the Brexit vote in June 2016? Yep, it’s been over 13 months. Even more impressive is that it’s been almost a year since we’ve seen even a 3% pullback, only the 2nd time since 1950 we’ve gone this long. The first was in 1995. (Source: LPL Research).
Market Drops are Necessary and Keep Markets Healthy
To paraphrase Hans Gruber in the Christmas movie classic, Die Hard, ‘we know that market drops are inevitable…In fact, they’re necessary’. Without them, optimism becomes excessive and can lull people into a false sense of security.
In the 2nd half of 1990’s for example, the market gained over 20% per year for 5 years in a row. This period of outperformance lead people to think that stocks had become less risky. I recall a front page Wall Street Journal article highlighting a barbershop that had switched its TV from ESPN to CNBC. Instead of talking about the Yankees, the patrons and employees were swapping stock tips.
While market drops are needed to correct market excesses, they can be uncomfortable, especially when we’ve gone so long without one. The good news is they are usually short-lived. Historically, a 5% pullback lasts about 7 weeks and 10% corrections average 4 months in duration. Even full blown bear markets only average a year in length. (Source: American Funds)
Majority of Pullbacks Don’t Turn into Bear Markets
Just because it’s been a while since we’ve seen a market pullback, that doesn’t mean it’s going to be severe. In fact, during bull markets such as the one we’re currently enjoying, market dips typically reverse fairly quickly. Within 3 months of a 3% drop, markets are higher 80% of the time with an average gain of 5.2%. (Source: LPL Research).
In general, since 1945, only 1 out of every 19 drops of 5% have gone on to become bear markets, defined as a loss of 20% or more. Even when markets drop 10%, it’s relatively rare that they continue to fall into bear market territory. In fact, only 14% of these corrections go on to become bear markets. (Source: Yardeni Research). And as much as we’d like it, don’t think any of the so called experts can predict when the next 5% drop will turn into a bear market, they can’t. (See The Forecasting Game)
So when markets do become turbulent again and finally do fall 5% or more, remember that it’s a common occurrence and will probably not last more than a few months. Also know that while we’re in bull market, any small corrections will likely not turn into something more serious. Actually, it could be just what the market needs to keep moving forward.