U.S. stocks have been trending solidly higher for over a year, with very few episodes of sustained downside volatility. From the bottom of the March 2020 Covid-19 bear market to the end of 2020, the S&P 500 charged +68% higher. In Q1 2021, the index rose another +6.2%, again with no material pullbacks. I don’t want to spoil the fun, but these types of extended winning streaks aren’t that normal.1
Since 1980, the S&P 500 has experienced an average intra-year drop of -14.3%. As you can see from a chart below of the S&P 500 over the last year (from May 1, 2020 to May 1, 2021), however, the equity market has not even come close to that kind of pullback. There was a patch of downside volatility during the late fall in 2020, but it did not produce a pullback of more than -10%. In fact, there has not been a double-digit pullback yet in this new bull market.2
S&P 500 from May 1, 2020 to May 1, 2021
Source: Federal Reserve Bank of St. Louis3
Am I claiming impending doom for U.S. stocks? Of course not. My outlook for equities is still positive based on our expectation of better-than-expected earnings and growth in the new year. But in my view, it does mean now is a good time to mentally prepare for a stock market correction. And I should make one thing clear before I go any further: a pullback of -10% or more would not be cause for concern, in my view. Just the opposite – I would see a correction as a sign of a normal, healthy bull market.
Let’s take a look back at the 2008 Global Financial Crisis bear market for a good example. When the bull market started in March 2009, the S&P 500 rallied +63% from the bottom through the end of the year – very close to the +68% rally following the Covid-19 bear. In 2010, which was the second year of that bull market, the S&P 500 endured an intra-year correction of -16%. The correction was scary at the time, but also healthy – the market finished up +13% in 2010.4 We have seen this very regularly throughout history, where the second year of a bull market is choppy but also finishes positive. I could see a similar outcome in 2021.
So, how should investors prepare for market volatility or a double-digit correction? Using history as a guide, I would offer two pieces of advice:
- Mentally prepare for a correction now, so when it arrives, you expect it and can avoid making any knee-jerk, reactive decisions.
- Review your current allocation to ensure your portfolio is well-diversified, which to me usually means investing across different asset classes, styles, sizes, and even regions. A broadly diversified portfolio can ‘smooth out the ride’ during market pullbacks.
At Zacks Investment Management, these pieces of advice are already baked into our investment decision-making process and our approach. We build diversified investment portfolios for every client based on their needs and their goals, and we manage assets within the portfolio based on proprietary research derived from Zacks Investment Research. In other words, we do not leave any room for emotional, reactive decisions, which is precisely where corrections tend to drive investors.
Bottom Line for Investors
The point of talking about the possibility of a stock market correction now is not to try and predict when the correction will arrive or to make a plan for trading in-and-out of the market during it. I do not recommend doing either.
Thinking about the possibility of a stock market correction simply helps us prepare mentally for a sharp and sudden pullback so that when it arrives, it does not tempt us into some knee-jerk portfolio response. Corrections are normal, healthy features of bull markets and equity investing in general. We should treat them as such.