Stock Market Corrections Are Never Fun

October, 2015
S&P 500: 1920
OUTLOOK MEMORANDUM
Stock Market Corrections Are Never Fun

The stock market is in the midst of a normal bull market correction similar to those that always have occurred around the time the Federal Reserve has begun to raise interest rates. Over the past 55 years these Fed-related corrections have lasted about five months and have had declines in the S&P 500 that have averaged about 10%. We now are more than four months into the current correction, and at its August low the S&P 500 had fallen 12.3% below its May 21 high. While this correction may yet have several months to run, we think the S&P 500 is unlikely to decline much below the August lows. Once these past Fed-related corrections have ended, the bull markets have continued for an average of another three years, taking the S&P 500 to significant new highs. Thus, our plan has been to ride out this correction despite the short-term discomfort it brings. We think the current bull market is likely to resume soon and last through 2017, with the potential to take the S&P 500 up another 35-40% above its September close, which would be 20-30% above its May high.

We all like to see our portfolios rising in value and dislike watching them decline. Most of the time, markets have slightly more up-days than down-days, so those down-days do not seem so bad and upward progress occurs gradually. During the early stages of bull markets, the stock market may post advances week after week, providing us with disproportionately more pleasure than pain. About once or twice each decade, bear markets occur due to fundamental problems in the economy. During these, the major stock market averages decline by 20-50% over a year or two and the pain is severe and persistent. In contrast, bull markets have occasional shorter periods of market decline measured in months rather than years that occur for reasons that generally are more psychological, and are less severe, with market declines of roughly 10-15%. These are referred to as corrections. Since these corrections often are driven more by psychology than fundamentals, are shorter, and are less severe, they are difficult to time. As long as we remain confident that the economic expansion cycle and bull market have considerable life left in them, we generally do not attempt to reduce our market exposure in anticipation of them. It is not fun to watch our portfolios lose 10-15% over several months, but the potential for short-term gain from trying to sell the correction and perfectly time our re-entry just is too small to justify the risk of missing the next leg up in the bull market.

Stock market corrections develop for many reasons, but they always have occurred in past cycles around the times that the Fed has begun raising interest rates. These corrections have reflected some variation of investor fear that the interest rate hike will damage the economic expansion. Since last year we have written that we thought the Fed would begin raising interest rates during the second half of this year, and that we expected the usual stock market correction once again to occur at about that time. Since our work has indicated a likelihood that the current bull market will last for at least a couple of more years, we have thought it best to just ride out this correction despite the discomfort we knew we would feel as it was occurring.

Many investors had expected the Fed to begin increasing its fed funds rate in September, but it did not. While the debate continues to rage about when it will do this, we have concluded that we now are experiencing the customary Fed rate-hike correction. In fact, the S&P 500 high for this bull market occurred on May 21, so we now are more than four months into this correction even though the Fed has yet to announce a rate hike. Recall that back then, stock prices began to weaken on concerns about the negative effects of the strong dollar on our economy as well as weakening commodity prices. In our view, these concerns were a consequence of the markets anticipating a Fed rate hike later this year. This expectation was the primary driver of the strength in the dollar. Since commodity prices generally fall when the dollar rises, the commodity price weakness also was linked to the anticipated Fed rate hike.   In June, fears that Greece would exit from the euro contributed to investor uneasiness, but, as we thought, this issue moved to the background by summer’s end.

While most short-term market price changes reflect the relatively unpredictable economic, political, and corporate news of the day, week, or month, the various phases of economic and market cycles reflect fundamental forces that are understandable and are much more predictable. One such major force is the effect Fed monetary policy has on the economy and the securities markets. Investors understand that an easy monetary policy boosts economic growth and generally is associated with rising securities prices. They also know that a tight Fed policy, if maintained, eventually will cause a recession that drives down stock prices. Thus, when the Fed begins to transition from an easy monetary policy to a tightening policy, investors become nervous even though they know that such Fed monetary tightening generally has taken years to end economic expansions in the past. This raises two questions. The first is: Why in the past has it taken a couple of years, or more, of Fed tightening to cause economic trouble? The second is: If investors know this, why do they sell their stocks when the Fed first begins to tighten?

The answer to the first question is that the Fed pumps a great deal of liquidity into the economy as it tries to boost it out of a recession and it takes years for the Fed to drain it once it decides to begin doing so. This can be seen in the following chart showing an index of economic liquidity we developed and have maintained for years. The shaded vertical zones indicate the periods of recession. The Liquidity Index always rises sharply as the Fed boosts the economy as it emerges from each recession, and then liquidity falls as the economy returns to growth over the following years. The upward-pointing black arrows indicate when the Fed began to raise interest rates in each cycle. In every case, this occurred years before the next recession because it has taken the Fed years to drain sufficient liquidity from the economy to cause a recession. In our chart, our Liquidity Index has had to fall below the horizontal 100 line and remain there for at least a couple of years in each cycle before the economy became so starved for liquidity that a recession developed.

Graph

The last recession ended in June of 2009, and the Fed has been supplying abnormally large amounts of liquidity to our economy since then. Currently, our index indicates that we still have a comfortable amount of excess liquidity in our economy. Even if the Fed begins to raise rates now, it is likely to proceed slowly and cautiously so that our Liquidity Index is unlikely to decline to levels below 100 associated with a recession for several years.

The answer to the second question is that investors overreact to each Fed tightening despite knowing that these initial rate hikes have taken years to damage the economy because each time they worry that “this time is different.” In 2004 their fears involved concerns about the Iraq War; in 1994 it was due to the slow recovery in jobs in the early-1990s related to the defense industry reductions that accompanied the end of the Cold War; and in 1983 it was the fear that the Fed would overreact in fighting inflation. Today’s “this time is different” fear is that falling commodity prices suggest that slowing growth in China is pulling the world economy into recession.   Of course, the strong dollar, falling commodity prices, and even the slowing of the Chinese economy all are reflections to some degree of the markets anticipating the Fed rate hike. This is one reason we view the current correction as being this cycle’s Fed rate-hike correction even though the Fed has not yet announced one.

While each market cycle has its own unique characteristics, the corrections associated with the Fed’s initial rate hikes have been relatively consistent. Understanding these patterns will make it somewhat easier to bear the discomfort of the correction.

Table

The table above summarizes these useful patterns for the seven rate-hike corrections of the past 55 years. Each column of the table is numbered at its top to make our reference to it easier. The key points to be gleaned from the table appear in the row in dark print near the bottom, labeled Averages. They are:

(1) From peak to trough, these corrections have last just over five months (Column 3), with the shortest having been two months (1975) and the longest being 9½ months (1983).

(2) From peak to trough, they have averaged declines of 10.2% (Column 6) with the smallest decline having been -2.4% (1961) and the largest ones having been -14.4% in 1983 and -14.1% in1975.

(3) It has paid to be invested at the bottom of each correction as the S&P 500 has rebounded by an average of 22.3% within the twelve months following the correction low (Column 7). The smallest 12-month rebound was 10.4% (1961), while the rebounds exceeded 30% in the 1971 and 1983 cycles.

(4) Once the corrections have ended, the bull markets have resumed and the ultimate bull market highs have not been reached until an average of 39 months after the correction lows (Column 10). The shortest period was eight months in 1968 amidst the Vietnam War, assassinations, and political upheaval of that year. There have been two bull cycles that have lasted more than 50 months beyond the correction (1961 and 1975), one that lasted another 71 months in the 1990s, and two that lasted 37-38 months more during the mid-1980s and during the last cycle.

(5) The gains in the S&P 500 following the correction lows to the ultimate bull market highs have been substantial, averaging 80.9% (Column 9). The smallest gain has been 22.7% in 1968, four of them have been in a 33-47% range (1973, 1966, 1980, and 2007), while the S&P 500 more than doubled following the 1984 correction low, and more than tripled following the 1994 correction low.

We now are more than four months into the current correction, closing in on the average period of about five months. The decline in the S&P 500 from its May 21st peak to its August 25th low has been -12.3%, modestly above the -10.2% average and close to the-14.4% of the largest such correction. Since the Fed has yet to find the courage to announce a rate hike, we may have a few uneasy months left before this correction ends. During this period, it is possible that the August 25th lows may be penetrated; but if so, given the historical record, we think it likely that the downside from here should be limited.

Beyond this, we think the economic and stock market outlooks are likely to remain favorable for two-to-three more years, which would be consistent with the historical pattern. As we previously discussed, liquidity remains at a relatively comfortable level and the Fed is unlikely to move aggressively to drain it to a level that threatens the economy with so many still not fully employed and inflation being well below the Fed’s targeted level. Since it generally has taken about a year of strained liquidity to cause a recession, the economy seems likely to continue its current expansion phase into late-2018 or beyond. This suggests a favorable stock market environment through 2017.

S&P 500 earnings always have exceeded their long-term trend-line by roughly 20% before the end of each bull market. This trend-line places 2017 S&P 500 earnings at $150. If they were only 10% above this trend-line in 2017, they would reach $165. The index currently is selling at about 16 times trailing earnings. We think PE ratios can increase during the next year or two, but if the S&P 500 in a bit more than two years were to sell at 16 times this $165 of earnings, it would reach a bull market high of 2,640. This would represent a gain of 37% from the September close. While there is no assurance that such gains will be realized, these earnings and valuations assumptions are reasonable and the projected returns are consistent with the post-correction returns achieved in most of the cycles detailed in our table. It will have been worth bearing the discomfort of the current correction if the next couple of years produce such gains.

Aside from unforecastable wars, natural disasters, or political upheavals, the development that might upset this happy scenario likely would be another financial “accident” like the 2008 Lehman bankruptcy that freezes the financial system and keeps liquidity (i.e., credit) from getting to the economy. Years of zero interest rates have driven households and other investors into various mutual funds, closed-end funds, and ETFs in search of income. Recently, there has been attention given to the substantial amount of household money, some of it from funds and ETFs, that has flowed into junk bonds. This market is highly illiquid and prices could drop significantly should mass selling develop. On the bright side, however, the major banks have very limited exposure to junk bonds today unlike their large exposure to mortgage-backed bonds in 2007-2008. Thus, the risks of a serious financial accident from a junk bond price collapse does not seem to be great, but we nonetheless will need to be vigilant to such risks.