Long-term investors shouldn’t worry too much about stocks falling 10% from their highs

Read Time:4 Minute, 10 Second

Traders work at the New York Stock Exchange (NYSE) in New York City, U.S., January 21, 2022.

Brendan McDermid | Reuters

Should you be worried?

On Monday, the S&P 500 fell 10% from its recent high.

However, panic-stricken investors should keep long-term trends in mind.

What is unusual is not that we have a 10% correction, what is unusual is how long the time between corrections is.

From February to March 2020, the S&P 500 fell about 33% before recovering.

Before that, the most recent 10% drop was in late 2018, when the Fed talked about aggressive rate hikes. That period — from the end of September to Christmas Eve — caused the S&P 500 to drop 19%.

That’s two corrections above 10% in the past 3 years and 2 months. This can be revised every 19 months.

While that sounds like a lot, it’s below historical standards.

5%-10% correction is normal

In a 2019 report, Guggenheim noted that corrections of 5% to 10% in the S&P are frequent.

They noted that since 1946, there have been 84 declines of between 5% and 10%, the equivalent of more than one a year.

Fortunately, markets usually bounce back quickly from these modest declines. The average time it takes to recover from these losses is one month.

Deeper declines have occurred, but they occur less frequently.

The S&P 500’s decline since 1946

decline # Rejection times Average recovery time (months)
5%-10% 84 1
10%-20% 29 4
20%-40% 9 14
40%+ 3 58

Declines of 10%-20% occurred 29 times (approximately every 2.5 years since 1946), 9 times of 20%-40% (approximately every 8.5 years) and 3 times of 40% or more (approximately every 8.5 years) 25 years).

Two takeaways: First, most pullbacks over 20% are recession-related (12 since 1946).

Second, for long-term investors, it tells you that even a relatively rare but severe 20%-40% pullback won’t last long — only 14 months.

S&P 500 gains in 3 of 4 years

Another way to slice the data: If you factor in dividends, the S&P has gained 72% year over year since 1926.

That means the market drops about once every four years. It can (and does) put together a string of down years.

But this is not the norm. In fact, the opposite is true. More than half the time (57%), the S&P was up 10% or more.

S&P 500

S&P 500 Annual Prepaid Percentage
20%+ advance payment 36%
Prepay 10-20% twenty one%
0-10% advance payment 15%
0-10% drop 15%
10%+ drop 13%

Fed: Is this a long-term shift in the stock market?

Will there be some deeper, longer-term correction, though?

Even the bulls admit that the past 12 years have been exceptionally rich for market investors.

Since 2009, the S&P 500 has gained about 15% per year on average, well above its historical return of about 10% per year.

Many traders attribute the annual outperformance of 5 percentage points to the Federal Reserve, which not only kept interest rates extremely low (providing investors with a lot of cheap money) but also injected a lot of money into the economy by expanding its balance sheet, which is now about $9 trillion.

If this is the case – and all or most of the excess returns are due to the Fed – then it is reasonable to expect that the Fed’s withdrawal of liquidity and rate hikes could result in a sub-normal (under 10%) return for some time to come.

This is the vanguard point of view. The mutual fund and ETF giant noted in its 2022 economic and market outlook that “the removal of policy support creates new challenges for policymakers and new risks for financial markets.”

They described the stock’s long-term outlook as “cautious,” noting that “high valuations and low economic growth mean we expect lower returns over the next decade.”

How much lower? They expect a 60/40 stock/bond portfolio to return roughly half of what investors have achieved over the past decade (from 9% to about 4%).

Nonetheless, Vanguard is not expecting negative returns, they are just expecting lower returns.

What does it mean for a stock to drop 10% from its high?

You heard all day Monday: “The S&P 500 is 10% from its high!”

True, but how much does this matter to the average investor?

How many people do you know who invested all their money at the top of the market and then pulled it all out at the bottom of the market on Monday? Yes, many people panic at the bottom, but few people invest all their money at the top of the market.

Most people engage in some form of dollar cost averaging where they invest over many years.

This means that when stocks pull back, they will almost certainly pull back from a higher price than you paid.

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