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Finally, A Correction Thumbnail

Finally, A Correction

Markets & Economics

Finally, A Correction?

By Jon Aldrich

We have been waiting the last several months for the inevitable stock market correction. Remember, stocks do not just go in a straight-line upwards, although it seems like that has been the case virtually the entire time since we came out of the COVID bottom at the end of March 2020. As you can see in the chart above of the S & P 500 over the last 12 months (Remember, if you want a better picture of the market, the S & P 500 is much better than the Dow Jones index) it has been a nice smooth ride up for investors over this time period. But there is also an old saying among investors that “Stocks take the escalator on the way up, but the elevator on the way down.” As I write this, we are having the worst day in the markets since all the excitement the market had in the COVID crash last February and March.

It probably makes sense that we would start seeing some “excitement” in the markets in the month of September, after all, it is the worst month for stock market returns. Since 1928 it has generated an average stock return of -0.99% and has shown losses 54% of the time over that period. Since 1950, it has had 32 up years and 39 down years with an average return of -0.62%, You can play around with monthly historical market returns with this calculator.

Many market participants have for several months now, been expecting a correction or at least some indigestion in the markets and going into the fall we have a number of catalysts (which I will get into below) that are finally causing that long awaited sell-off in the markets. As I write this, the S & P 500 has fallen about 4.26% since the start of the month, so we have not even hit a 5% correction yet, and of course the media is freaking out as the market has been way too calm for them and they need some excitement to bring eyeballs in.

It's been a while since CNBS could trot out the scary headline in red! FEAR SELLS.

First, let’s refresh our memories as to how often stock market “corrections” occur. The following graphic is a couple of years old, but still very informative, as not much has changed with these figures:

As you can see, on average there are about three 5% corrections in the market each year, we have gone over a year without one, but it looks like we might finally have one. Also, there is a good chance the current market sell-off could go further then -10% which usually happens about once a year.

Of course, I don’t really need to remind people that market corrections are a normal and healthy part of the market. The longer markets go up and up and up without even mild corrections, the greater the chances of a market “bubble”. And I think we can all agree that market “bubbles” that pop are no fun for most people.

What are the Possible Catalysts for a Market Correction?

As mentioned above, September has historically been the worst month for the markets, so that is a good starting point for the possible catalysts. I have yet to see concrete reasoning for why September has been the worst month, but you can see some of the rationale that has been discussed here.

  1. Fears of a Large Chinese Real Estate Developer defaulting on its debt – Evergrande, a property developer in China that is deeply indebted may be unable to make its next bond payments in a few days and if the Chinese government lets the company fail, it will inflict large losses on the shareholders and bondholders of the company. True, the company’s operations are almost solely based in China, but there are many global debtholders such as banks and other institutional investors that will feel the ripples of a default and it would be somewhat of a shock to the financial markets for a bit.
  2. Market Valuations are not Cheap – The market has been on quite a run coming out of the COVID crash last year, but this also means that the market is getting expensive when compared to its historical valuations. As we are starting to see some slowing economic growth from the Delta variant of COVID and higher inflation, it has created a little more caution in the markets than we have had in some time.
  3. Higher Inflation – As I wrote back in May, and as we are all seeing at the grocery store and pretty much everywhere else, we are in a period of higher inflation and that often creates a headwind for stocks as profit margins decrease as not all companies can pass on the price increases to their customers.
  4. Delta Variant of COVID – You see this in the headlines all over as we continue to have to deal with COVID, it does dampen economic activity as there is still quite a large subset of the population that really does not want to travel, go to restaurants, movie theater, etc. Thus, it is difficult to get back to a full “open” economy until this subsides. Many companies have pushed back reopening dates for getting people back in the office and this causes less spending as people continue to remain at home.
  5. Debt Ceiling & Budget game of Chicken (Again) – Every few years we have to go through the government nonsense of having to vote to raise the debt ceiling or else the government is unable to pay all its bills, and the specter of a US Government Technical Default is a possibility. Congress needs to act by September 30 (the end of the Federal Government’s fiscal year) to raise the debt ceiling or else face the risk of missing payments to Social Security and the military. We seem to play this partisan game of chicken every few years. Of course, all this garbage makes the markets uneasy. Debt ceiling vs government shutdown 2021: What you need to know (cnbc.com)
  6. Federal Reserve Meeting and possibility of Unwinding Easy Money Policies (The Taper) – Market participants will also be watching the Federal Reserve meeting this week to see if there are more clues or a timetable is set to reduce its massive bond buying program that was put in place during the COVID crash to stabilize the markets and flood the economy with cheap credit.
  7. Looming Tax Increases – House Democrats have released the text of their proposed tax increases and there is a good chance many of these will eventually become law.

 As you can see there are plenty of events for markets to be concerned about over the next few months. But on the positive side, markets also need a “wall of worry” to continue to advance in the longer term. Once the markets can come to grips with the above issues, there is a good chance it can resume the uptrend. However, we also need to be prepared for a 5%, 10% or maybe even a 20% correction in the near future. As long-term focused investors, this is par for the course and while it may not be fun to endure while we are in the middle of it, we will eventually get past it.