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Guide to the Market Correction: Part One

| February 13, 2018

Last Thursday, the stock market officially entered ‘correction’ territory. Technically speaking, a correction occurs when the market falls by 10% from its previous peak. While corrections are not particularly enjoyable for investors, they are fairly routine events that occur, on average, once a year. If the market was to fall such that it was 20% below the peak, that would constitute a ‘bear market’.

In terms of market impact, the difference between a correction and a bear market is more than just a matter of the threshold of the downturn. According to Goldman Sachs Chief Global Equity Strategist Peter Oppenheimer: “The average bull market 'correction' is 13 percent over four months and takes just four months to recover”. On the other hand, he notes that the average decline during a bear market is 30 percent, and normally requires 22 months before a full recovery.

Given the stark difference between corrections and bear markets, it is not surprising that market watchers are spending a great deal of time trying to determine which the market is currently facing. At present, there are three fundamentally different narratives to explain the stock market’s recent volatility and its root causes:

Narrative #1: “The market went up too quickly in January and the buying just exhausted itself, so a correction was inevitable. Investors are searching for an explanation so they are seizing on interest rates, but that’s just an excuse – interest rates had nothing to do with this correction. If an excuse is needed, look to the institutions that had short volatility trades. When they were forced to unwind these positions, the market really took a hit. Quantitative strategies like risk parity and momentum trading also drove the market down. Now that these weaker hands are out of the market, we can get back to focusing on strong earnings and the fundamentally positive macro environment.”

Adherents to this theory point to the fact that while equities have been distressed, other assets like credit or currencies have been more stable. They argue that if this downturn were more than just a short-term technical move, there would have been a flight to higher quality credit and the yen. Bottom line: Short-term correction.

Narrative #2: “This move started when we finally saw inflation in the data [when the Feb. 2nd Employment Situation Report showed that average hourly wages grew by 2.9%]. The bond market reacted and interest rates shot up, which naturally caused the stock market to tank. Sure, margin calls resulting from the short volatility trade and quantitative traders helped drive the market down, but this correction is based upon a fundamental repricing of assets given that interest rates are higher. Fortunately, the bond market, which had been fighting the Fed, is now helping the Fed by raising the cost of capital and thereby helping to contain inflationary pressures.”

Until a few weeks ago, the Federal Reserve and the bond market had been fundamentally at odds with respect to the rate of change in inflation and interest rates. It appears that the Fed, for the time, has won and the bond market now recognizes the likelihood of more significant inflation. For equity markets, it will take some time to adapt to higher rates and understand the impact on corporate profitability and investment flows. Bottom line: Normal correction.

Narrative #3: “The rise in interest rates has been forecast for a long time now. Unfortunately, rates still have to go much higher for two reasons. First, the market may have caught up to the Fed, but the Fed itself is behind the curve. Labor inflation has been tame for so long because of the huge overhang left by the financial crisis ten years ago. Now that that overhang has been exhausted, inflation is here and it’s not going anywhere – especially after you factor in the fiscal stimulus from the tax reform bill. Second, ambitious plans for government spending will necessitate the issuance of an excess of Treasury debt. This will mean much higher bond rates that will ultimately draw money away from equity investment. So inflation and interest rates will march much higher, and equities markets will have to adjust for significantly higher costs for capital and labor as well as increased competition for investment flows.”

Bear markets oftentimes coincide with recessions, but have occurred due to other pressures. If more inflationary data points are released and the yield on the 10 year Treasury Note marches past 3% without stopping, this version of events may turn out to be correct. Bottom line: Bear market.

It is too early to know which of these three story-lines comes closest to the truth. Fortunately, the principles of portfolio construction don’t change due to a correction or bear market. Additionally, for long-term investors, even more prolonged downturns are not meaningful when considered against the backdrop of a long-term investment and retirement plan. Still, there are things that investors can and should do during a correction. That will be the topic of the companion piece to this blog that will be coming shortly. Stay tuned…