Volatile Stock Market’s 10% Correction Stokes Investor Fears

The Dow Jones industrial average plunged more than 1,000 points twice this week. More significantly, the Dow and Standard & Poor’s 500-stock index have now each lost more than 10% from their all-time highs set just two weeks ago. The stock market is officially in a “correction.”

Corrections are surprisingly commonplace, typically occurring about every two years. And as the word implies, the market is correcting its excessive previous rise. Stocks moved too high too fast, by this definition.

The crucial question for today’s long-term investors, of course, is does the selling stop here or do we plunge another 10% or so into official bear market territory? I’ll examine the evidence, which is increasingly worrisome, momentarily.

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But first: There’s a reason this correction feels worse that any correction I can recall in 35 years of watching markets. It’s not your imagination. Blame it on large numbers. In 1987, the Dow plunged 508 points in one day—and sustained a loss of 22.6%, the largest one-day decline in the Dow’s history. On Monday and again on Thursday, the Dow lost almost twice that many points, yet the combined loss from both days was only 8%.

Additionally, it has been two years since the last correction, and the market was less volatile in 2017 than it had been in any calendar year since 1964. We grew accustom to smooth sailing.

What’s more, the correction happened so quickly. Less than two weeks earlier, on Jan. 26, stocks achieved record highs. No doubt the computer programs that dominate stock market trading played a huge role in how rapidly the market sank. So did the exchange-traded instruments that profited from low market volatility—and got clobbered when volatility spiked.

What’s driving investors’ fears of a stock market crash?

But fundamentally, there have been a couple of changes in the outlook in the past two weeks. Bond yields are rising. That makes it more expensive for companies to borrow, reduces the present-day value of companies’ future cash flows, and makes bonds more competitive with stocks for investors’ dollars.

Incoming Federal Reserve Chairman Jerome Powell hasn’t given any indication he’ll push interest rates up more rapidly than Janet Yellen would have. But the Fed is expected to raise rates three times this year. Increased federal borrowing to pay for the gargantuan tax cut and the government’s giant two-year spending plan put real upward pressure on interest rates.

Then there’s inflation. A little, and that’s all we have now, is a plus for the stock market. But if inflation shows signs of accelerating, the Fed will raise rates higher and faster than currently expected—which would likely kill the nine-year-old bull market.

There are other reasons to worry. Jim Stack, president of InvesTech Research, is my longtime favorite strategist. He reduced his allocation to stocks over the last two weeks, just before the selloff, from 82% to 74% and is focusing on defensive stocks: consumer staples and health care.

He’s not predicting a bear market yet, but plainly the risks have risen. “Whether we have seen the final bull market highs, it’s going to be a volatile, unsettling year for investors,” he says.

Stack bases his concerns partly on the high stock market valuations, rising bond yields and a falling dollar.

But his key worry is that the market’s technical picture is eroding. Technical analysts look at the action of the market itself to predict which way it will go. They get bearish when they see increasing numbers of stocks making 52-week lows, as well as a narrowing of the number of stocks going up. When investors are clustering in a handful of stocks or a couple of sectors, dangers rise.

Stack isn’t predicting a bear market yet because the economy is so strong. But he’s getting more worried, and he doesn’t expect a quick rebound for stocks. He thinks the market highs are in place for at least the next several months and possibly for the rest of the year.

Bear markets vs. stock market corrections

The strong U.S. economy is certainly a plus for the bull market. Unless and until we get strong signals that leading economic indicators, such as consumer confidence and purchasing managers plans, are sharply weakening, it’s hard for me to see a recession anytime soon. And the stock market almost never slips into a bear market without a recession either already here or in sight.

Only about one in three corrections lead to bear markets. Since the end of 1945, the market has sustained 21 corrections, defined as losses of 10% to 19%. (This doesn't include 12 other corrections that blossomed into full bear markets with declines of 20% or more.) The peak-to-trough declines of corrections averaged 14% over five months, and it took only another four months for the market to fully recover.

Bear markets are another story. Peak-to-trough declines average 33% over 14 months. And it takes an average of just over another two years for the market to recover its lost ground.

One note of optimism comes from Sam Stovall, chief investment strategist at CFRA Research. “Sharp and swift selloffs have traditionally led to quick conclusions and rapid recoveries,” he says.

I wouldn’t sell into this market—yet. But if you want to reduce your risk, consider shifting some money into these high-quality mutual funds: Parnassus Core Equity Investor (symbol PRBLX), American Funds American Mutual Fund F-1 (AMFFX), AMG Yacktman Fund (YACKX) and FPA Crescent (FPACX). I recommended all four funds last March as hedges against a bear market because the funds are highly likely to hold up much better than the major market averages if stocks continue to tumble.

Steven Goldberg is an investment adviser in the Washington, D.C., area.