Broker Check

What Might the Next Correction Look Like?

| August 25, 2020
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                The first quarter coronavirus-induced correction saw the S&P 500 fall a little over a third to a closing price of 2,237.40 on March 23rd. By June 8th, the S&P 500 was within 4.5% of all-time closing highs even with an economy that was partially shut down. As of August 24th, the S&P 500 made a new all-time high and was up 6.2% for the year despite close to two hundred thousand COVID-19 deaths, ten percent unemployment, and a still struggling economy.

                The crash was extreme and not analogous to anything we have seen since 1987, but it should be noted that the frequency of “flash-crashes” and quick corrections has been increasing during the last few years. Interestingly, these pullbacks have reversed very quickly. Prior to the first quarter of 2020, the market experienced a rapid sell-off in the fourth quarter of 2018 at the end of a Federal Reserve led tightening cycle. The S&P 500 closed at 2,930.75 on September 20, 2018 and then fell 19.8% to close at 2,351.10 on December 24th. The Index had regained its prior highs by closing April 23, 2019 at 2,933.68 before reaching a then all-time high of 3,386.15 on February 19th.

                In August 2015, the S&P 500 fell 11.2% over a nine-day period as fears of a China slowdown rippled through global markets. Over the next twelve months, several quick market drops occurred presumably due to falling oil prices and Brexit. Nonetheless, the S&P 500 quickly rebounded and moved back to all-time highs or exceeded them. There have been numerous rapid selloffs over the past five years and all of them have unwound quickly.

                Flash-crash frequency has been rising, but the reasons are not entirely clear although several theories have been suggested. The market is increasingly dominated by algorithmic traders – computers that have been programmed to trade based on a multitude of factors. One of the inputs is volatility and a lot of quantitative investors are concerned with mitigating losses. Increases in volatility lead these algorithms to reduce risk by selling risky assets such as stocks which leads to more losses and higher volatility until positions are reduced sufficiently to account for the new trading environment. Once these traders have reduced their positions and recalibrated risk sufficiently, the selling pressure evaporates, markets quickly stabilize, and money moves back in as trailing volatility subsides.

                While the reasons for the increasing frequency of quick selloffs remain unclear, the main drivers behind the rebounds do not. The markets and economies are increasingly being driven by large technology and internet stocks, many of which are based in the United States. The rapidly growing earnings of these companies makes it tough for the indices to remain down for too long. Additionally, the Federal Reserve and other global central banks have provided significant liquidity that has supported global financial markets. Lower interest rates have provided valuation support for the S&P 500 and other broad equity indices. After the coronavirus recession, fiscal support joined monetary stimulus to cushion global economies which served to support asset markets.

                What does all this mean? It means that investors should probably remain invested at their target weights despite the lurking issues markets face. Global liquidity could begin to dry up, regulators could break up “big tech,” the number of new Covid-19 cases could rise significantly, or interest rates could rise which would cause valuations to be questioned. However, If the past is any indicator of the future it suggests that should any of these issues cause a rapid sell-off, it will likely be short-lived and lead to a buying opportunity. At that point, things will return to “normal” and the market will continue its long-term trajectory upward.

 

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