Don’t Let Fears of a Correction Derail Your Financial Plan

When will the next recession or market correction occur? It’s a question whose answer is difficult to exactly pinpoint; nonetheless, investors ask it far too often — especially when markets appear “pricey” or “disconnected from reality.”

Fears of an imminent bear market can drive investors to make critical mistakes that derail a financial plan, or they may avoid investing altogether (another mistake). Investors and market commentators get particularly nervous when valuations appear “rich,” but markets are rarely expensive across the board. Every single day, investors decide where to allocate capital, and the cheapest relative segment eventually attracts the most. Therefore, stocks’ prices simply reflect their relative valuation to all other alternatives.

“The stock market is where it is, valuation-wise, because bond yields are low and cash yields nothing,” says Brent Schutte, chief investment strategist at Northwestern Mutual. “Even so, there are always sectors of the market that are fairly valued. Heck, even in 1999, perhaps one of the greatest bubbles in history, there were relatively cheap stocks in certain sectors that performed quite well even after the bubble burst.”

Of course, market-wide corrections and recessions are going to occur. Economic turmoil is unsettling; no one wants to see their net worth decline in a short period of time. However, as humans, we’re hard-wired to overamplify the probabilities associated with frightening events. For example, far more people are afraid of shark attacks than heart disease even though the odds of developing a chronic heart condition are multiples greater than a fatal encounter with a shark.

That’s why it’s important to quantify market risk with hard data rather than perceptions, and Northwestern Mutual’s investment team recently did exactly that. What they found should give investors confidence to stick with their financial plan when the next correction or recession inevitably occurs.

LESS FREQUENT, SHORTER DURATION

NM reviewed price data going back to 1950 and found there were 24 separate occasions on which the S&P 500 (U.S. Large Cap stocks) fell by more than 10 percent, which is defined as a correction. That may surprise you — only 24 times in 70 years have U.S. large-cap stocks fallen by more than 10 percent. Of those corrections, only 10 have turned into bear markets, which is defined by a drop of more than 20 percent. Of those 10 bear markets, seven occurred while the economy was experiencing a recession.

“On average, investors will experience a correction roughly every three years and a bear market every seven years. While you do not know ahead of time if a correction will become a bear market, odds are it will not, as corrections turn into bear markets less than half of the time,” says Steve Bruce, senior investment consultant at Northwestern Mutual.

Going a little deeper, the average loss during a pullback that isn’t linked to a recession is 16.4 percent, with the average time to hit bottom being four months and the average breakeven recovery period (the time it takes to regain your losses) being 10 months. Contrast this with the average recessionary pullback being a 32.1 percent loss, taking 15 months to bottom and 38 months to recover losses. We should further note that these are based upon prices only, not total returns that assume reinvested dividends (which would certainly shrink the timeline to breakeven).

A FEW TAKEAWAYS

First, recessions and corrections occur less frequently than you might believe given the near constant drumbeat in the media that markets are “due” for a pullback. There’s an old saying: Economists have predicted nine of the past five recessions.

Secondly, when they do occur, they don’t stick around for a generation — particularly if a correction isn’t coincidental with an economic recession. Of the 24 corrections and bear markets, nearly half, or 11, lasted eight months or less. Even the 38-month average recovery period during a recession is a relatively short duration, considering our equities investment horizon of at least five years or more.

“Sure, some corrections or recessions will be longer in duration, but nearly half reach breakeven in roughly eight months or less. Let that sink in,” says Schutte. “An advisor will account for a few corrections and recessions in your long-term financial plan, which breeds confidence to hold fast when markets falter. Financial prosperity isn’t attained during the good times, but rather by your actions during the difficult times. Can you avoid the urge to sell and deviate from your plan?”

While corrections and recessions are portrayed in catastrophic proportions in the financial press, a 16 percent decline in an average correction (32 percent during a recession) can be managed and accounted for in a financial plan.

“Despite this volatility, the S&P 500 has ended the year positively 70 percent of the time over the past 20 years,” says Bruce. “Volatility is a persistent feature of the stock market. Respecting — not fearing — volatility can help you maintain investment discipline to help you reach your future financial goals.”

A STRONG LINK BETWEEN MARKETS AND THE ECONOMY

Through much of 2020, one refrain we heard often was that markets had completely detached from reality. After the fastest descent into a market recession in spring, stocks posted a swift recovery that hasn’t slowed down since. That rally carried forward through the second half of the year, even as the pandemic worsened, vaccines were still getting initial approvals and parts of the economy remained locked down. How in the world could stocks rise in such an environment? Many wondered if the market recovery was simply a mirage.

But throughout 2020 we reminded investors that this wasn’t a financial crisis; it was a health crisis. Rather than a systemic failing of the financial system, the 2020 recession was more akin to a natural disaster that causes an acute but temporary disruption. Markets and the economy “paid a price” to fight the pandemic through social distancing policies and massive monetary and fiscal stimulus. But the underlying foundation for economic growth remained intact, and vaccines would be rolled out in 2021.

Markets understood this and sniffed out a late-spring/early-summer return to normal, and that fueled the rally that started in spring 2020 amid a seemingly grim reality.

Sure enough, the National Bureau of Economic Research recently declared that the coronavirus recession officially ended in April 2020, even as COVID-19 continued to deeply impact everyday life. At just two months, it was the shortest recession in U.S. history. What’s more, that timeline basically mirrors what happened last year in markets. In other words, markets weren’t detached from reality at all.

Why do we mention this at all? Because it simply reinforces the historical analysis above. Non-recessionary corrections and bear markets tend to be sharp but brief, and there’s a strong link between the market and the underlying economy — even if they seem detached.

“The stock market and the health of the economy are intertwined,” says Bruce. “Not surprisingly, during periods of economic recessions — when there is a significant decline in economic activity — stock market declines tend to be more severe and last longer.”

During the pandemic, business activity wasn’t depressed due to economic constraints; it was depressed intentionally to fight a virus — hence a short yet severe recession. Now, following a rapid recovery, stock valuations are becoming the concern du jour.

“We don’t see a recession for some time into the future, which, to me, means any pullback would likely be short because a strong economy would pull markets with it,” says Schutte. “We still have time left in the economic cycle, which means we have time left in the market cycle.”

For those waiting on the sidelines for the right dip to come along, consider the 70-year history of recessions and corrections from the other side of the table. These events don’t occur all that often, which means you may be waiting several years for that “perfect” entry point to arrive. How far could markets climb in that time frame? It’s anyone’s guess. However, we do know cash equivalents have trailed all other asset classes in terms of performance for over a decade.

KEEP CORRECTIONS IN PERSEPCTIVE

Think about the 24 times in the past 70 years that tempted investors to sell and lock in losses. When you sell at the bottom, you miss so much of the upside that inevitably occurs on the opposite side. Just 24 brief periods in the span of seven decades could define your success or failure, and we encourage you to keep this in mind if the market falls.

No one can consistently predict whether a correction will become a bear market or when the economy will enter a recession. However, you can eliminate the need to guess by working with a financial advisor who will pair a forward-looking investment philosophy with a properly diversified portfolio that will deliver strong, risk-adjusted returns regardless of market environment.

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. Information and opinions are derived from proprietary and non-proprietary sources. All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against a loss.