Is it Correct to Call this a Correction?
Whenever the market is in the midst of a selloff, no one is ever sure when or where it will end. The S&P 500 has now nearly fully “corrected” from its intraday high on September 19, down almost 10% to its intraday low on Wednesday afternoon. The Dow fell only 8%, the Nasdaq 11%, and small-caps 14%. So, it’s not even clear that this has been a correction, but we’ll call it one, because under the top layer of the market, most stocks are down a lot more than 10%. A lot of the largest companies (like the core stocks) have propped up the indices.
Corrections are very common in bull markets; in fact, every year has an average of 3 5% corrections and 1 10% correction. A correction of more than 20% is called a bear market, and this happens every 3.5 years.
You may have heard that September and October have been home to a lot of corrections, and you would be right. So when it does happen, like now, it almost seems like a self-fulfilling prophecy. Still, when you’re sitting in the valley of the market’s year-to-date chart, having seen gains for the year evaporate from 10% to 0%, it’s not fun:
It’s always instructive for us to look back at some years in the past to gauge just how worried we should be. First stop is 2012:
After a very unsettled 2011, when the stock market was very volatile and ended the year with no gain (and global stocks fell hard), 2012 saw the return of relative calm. The market sprinted out of the gate and was already +13% by early April. Then the market endured its most recent 10% correction, and by early June, the year-to-date gains were only 2%. Stocks then rose 15%, then a post-election hangover brought the market back down 7%. A recovery after that took the full-year total return to +14% (including dividends). So, the year featured a 10%+ correction and another 5% correction, and still was a good year. As usual, stocks finished the year with a “Santa Claus rally.”
In 2011, a rising stock market to begin the year was hit by a rolling series of shocks through the year, starting with the tsunami in Japan and Arab Spring uprisings, which caused oil prices to spike up. The European debt crisis (and subsequent recession) and our government’s “near-default” on bonds precipitated the 20% drop in stocks in July and August. At its worst point, the S&P 500 was -13% for the year! By the end of the year, it was back up to +0% (+2% including dividends).
In 2010, the market’s chart looked like an elevation chart on a tough day in the Tour de France. Up, down, up, down, uppppp. At its worst level, the market was -8% year-to-date, but ended the year +15% including dividends.
Reaching back into the last millennium, many notable corrections took place in the fall. In 1998, the market rose 22% by mid-July, then fell all the way down to negative territory for the year in October, only to finish the year +27%. The backdrop had a lot of similarities, especially that the U.S. economy was the only major economy still growing, as emerging market economies (the Asian Tigers of the day) stopped growing, their currencies got devalued, Japan was dragged into recession, and Europe was stagnant. The Fed stepped into lower rates briefly, the U.S. economy was unscathed, and stocks were back off to the races for the final sprint into the peak of the dot.com bubble.
1997 was a relatively ho-hum year for the economy, but not for stocks. Greenspan had already called the market “irrationally exuberant” in December, 1996, and the market grew in confidence that he was wrong. Stocks shot up 10% to start the year, then round-tripped back down in March and April. But by October 7, stocks were +33% for the year. Then the market sustained a quick 11% drop, lasting only 20 days, and it was back up after that.
All of this history is to show you how common corrections are, especially in October. We’ve shown the chart before that this phenomenon is especially pronounced in mid-cycle election years, like 2010, 2006, 2002… For all these midcycle years from 1930-2010, by this time in October, the market is normally down 2% for the year. But the average subsequent gain is 6% to year-end, and a whopping 30% over the next 12 months!!!! The worst of the bunch was 1978-79, when the market gained only 12% from its lowest point in 1978. Now, remember that that requires you to catch the bottom when you buy, but still, those are pretty good odds, and we’re only 4% above the Wednesday intraday low as we go to print.
As for the concern over falling oil prices (wait, I thought we were supposed to be concerned when oil prices rise?), the following chart shows how volatile oil has been in the last 5 years:
Oil had big spikes in early 2011 and late 2011/early 2012. The sharp spikes were driven by concerns about shortages in the supply of oil, like when there is violence in the Mideast. Once the supply concern wanes, so does the oil price, bottoming between $75 and $80 per barrel each time. In 2014, while supply concerns (ISIS/Iraq, Ukraine/Russia) helped support prices above $100, they didn’t create any spikes, per se. However, U.S. production growth and a more stagnant outlook for oil demand growth have caused the correction in oil this time. As a result, energy stocks have been shellacked during this stock market correction, whereas some sectors have seen stock prices barely fall, notably consumer staples (stocks like Coke, Pepsi, Kimberly-Clark, and P&G).
We all like a good fight, and the media has helped to create one in the form of U.S. oil producers vs. OPEC. As the price of oil continues to drop, who will cave in first and cut production? It’s a game of chicken! We can envision CEOs sitting at their computers watching the price fall and emitting a maniacal laugh (anyone see The Muppets movie…Tex Richman?) as they write blog posts about OPEC’s budget break-even points. When in fact, oil CEOs these days are a little more calculating in how they manage their companies than the swashbucklers of the late 1970s.
But it is true that most of the new oil supply that’s been added in the world in the last 10 years has been fairly high-cost in terms of extracting and transporting. U.S. shale, deepwater ocean drilling, and when the next frontier is the Arctic, you know the low-hanging fruit of oil production has been picked. Below $75 or $80, a lot of oil wells become money losers. So, production will likely be shut down on those wells, causing supply to drop, and thus creating a natural floor for the price of oil.
Wells in most Arab countries are pretty low-cost, but these countries have built their entire economies on the back of oil, and their government budgets have risen over the years as their revenues have risen. It’s a lot easier to add spending than to cut it. So, those “break-even” points we hear about government budgets should mean something. Russia: $110. Iran: $136. Nigeria: $125. Venezuela: $120. Saudi Arabia: $92. The lowest, UAE, is $90. With oil at $83, they’re all hurting. Of course, we can’t judge them for running budget deficits, because the U.S. is pretty good at it, but those countries don’t have a reserve currency like we do.
We also must be careful not to get caught up in geopolitical and other global events, which may not end up having any effect whatsoever on investment fundamentals. Ebola is a very serious problem which we don’t want to minimize, but the odds of it turning into something like the Spanish Flu of 1918, which would have some effect on fundamentals, seems minute. There may be people with differences of opinion, and it’s not from vast expertise in viral diseases that we stake our opinion, but we’ve seen this movie so many times that it usually ends the same way. SARS, MERS, Bird flu, swine flu, mad cow, foot-and-mouth disease, even AIDS. Every time there’s a new disease, there’s a new worry, because it’s new.
Who knows if there is more correction to come? Could be. Or at least there could be a retest of the lows seen on Wednesday. But we all must recognize that bull markets generally end when economies fall into recession. As of now, the economy is reasonably strong enough to withstand a host of exogenous shocks, and yet still hasn’t grown enough that it has a lot of room to fall. Goldilocks lives on! In fact, the economic recovery might endure much longer than was previously assumed, if it keeps slogging through at 2% growth. As for stocks, TINA lives on! Throughout this recovery, stocks have consistently been way cheaper than bonds. Strategas has used “TINA” to describe stocks; with cash yields at 0% and bonds modestly north of 0%, for the investor seeking yield and inflation protection, There Is No Alternative (TINA) to stocks. Now that bond yields have collapsed once again in the past month, There Is No Comparison (TINC) might be more apropos!