Opportunity amid the pullback

There’s an old saying that investors should try to be fearful when others are greedy, and greedy when others are fearful. While market developments in the past week certainly had some investors understandably nervous, a closer look at the data suggests that this might be a time for getting in, not out.

My research focuses on analyzing market history to uncover patterns and probabilities that can help challenge investors’ biases and provide a more objective foundation for investment decisions.

Currently, my research suggests that the market’s recent stumble was likely a normal temporary pullback in the middle of a longer-term uptrend. More market stumbles are always possible—particularly over the short term, which is notoriously impossible to predict. But for investors who can look past any near-term bumps, this could prove to be an opportune time to get into certain segments and sectors with catch-up potential.

Here’s more on my 3 biggest takeaways for investors right now, including where I see the strongest opportunity potential.

1. The job market may be stronger than it looks

Let’s start by unpacking the main economic news that sparked the selloff. The first sign of potential weakness came from a reported slowdown in a manufacturing employment index.¹

The second sign came from unemployment data, which showed the US unemployment rate increasing to 4.3% in July (up from 4.1% the previous month).² Taken together these data points sparked investor worries that unemployment could be not just rising but accelerating, and that the US might be irrevocably headed for recession.

News reports on the “Sahm Rule” might make it sound like a recession is now unavoidable.³ But in truth, the causes behind an unemployment uptick matter. In a recession, unemployment typically goes up because companies are using fewer workers (i.e., they lay people off and do less hiring). But the recent uptick has been almost entirely driven by more people coming into the labor force. In fact, labor-force participation among the 25 to 54 age range hasn’t been this high in decades.

In recessions it’s more common to see the reverse, with job seekers becoming frustrated and leaving the workforce. It’s not impossible—but it is relatively rare—to see labor-force participation increase in the lead-up to a recession.

Moreover, in the bigger picture the key driver of the labor market is corporate earnings. If employers are making healthy profits, they generally aren’t laying off workers. Second quarter earnings recently looked on track to notch double-digit growth, and I believe profits may continue to accelerate from here. Rising profits could keep supporting the labor market, in a virtuous circle that also helps support the economy and stock market.

2. Market signals suggest we’re not entering a recession

To be sure, the recession question is vitally important for investors. The 6-month periods heading into recessions have historically been some of the worst times to be in the market, with it often taking years for investors to recover. Non-recessionary pullbacks—i.e., when the market corrects even though the economy continues to expand—have historically been much less severe, with investors recovering in a matter of months.

While earnings have been giving some clues on economic fundamentals, I also like to look for signals in the market data itself. One key signal I noticed in the past week was the rapid rise in the VIX, an index of implied volatility that’s also a useful yardstick for the level of fear in the stock market. While intuition would suggest that a steeper rise in the VIX signals a higher likelihood of recession, in fact the opposite has historically been true (perhaps a sign that extreme fear reactions in the market are more often overdone, compared with more moderate fear reactions).

I turned up an even stronger signal by comparing fear in the stock market with fear in the bond market, which investors often measure with changes in credit spreads. Credit spreads measure the amount of additional yield that investors demand in exchange for taking on credit risk, such as with high-yield bonds. When investors become more worried about economic conditions, they demand more yield for taking on credit risk, so credit spreads increase. While credit spreads did increase in the bond market in the past week, they increased by much less than the jump seen in the VIX.

In other words, the stock market has looked much more worried in the past week than the bond market. Historically, more than 80% of the time, big discrepancies in those fear indexes like what we saw in the past week corresponded with a non-recessionary market pullback. And in 100% of historical periods with similar dynamics in those indexes, the stock market went on to advance over the following 12 months (though past performance is no guarantee of future results).

To put it very simply, when the stock market panics but the bond market doesn’t, often the bond market turns out to be right. (Another old saying in investing is that sometimes, the bond market is smarter than the stock market.)

3. Investors might look back and see this as a buying opportunity

There are no certainties in the market, but based on the evidence, I believe this period will most likely turn out to be a steep pullback in the middle of a broader uptrend. Historically, that has actually been a positive signal for stocks’ subsequent performance. And if I had to choose between battening down the hatches or pursuing opportunity, I would use this moment to pursue opportunity.

In my opinion, there are 2 main areas where the strongest potential opportunity might lie:

Interest-rate-sensitive sectors

Specifically, the real estate and financial sectors look potentially compelling. Sectors that are sensitive to interest rates, such as these 2, usually lead in the run-up to a first rate cut. This year has been unusual because these sectors have instead lagged (in fact, performing roughly the way I might expect before an interest rate hike). Both sectors also have shown low valuations, which may provide a margin of safety and indicate that the sectors are pricing in too much bad news. If or when the Fed does cut rates, as the market is expecting for September, these sectors could see strong catch-up potential.

Small- and mid-cap stocks

The dynamics at play in the market this year, with earnings accelerating and the Fed poised to start cutting rates, have historically provided a positive environment for small- and mid-cap outperformance. At the same time, the valuation gap between large companies and small- and mid-sized companies has rarely ever been so wide. Like gradually stretching a rubber band, these factors have loaded small- and mid-cap stocks up with catch-up potential.

In conclusion

Markets don’t go up in a straight line. Market corrections and steep pullbacks always feel like a panic. But in fact they’re very common. Historically since 1962, most calendar years have included at least one market pullback of 5% to 15%. There’s always a reason for them, at the time, and yet they are normal and healthy corrections.

Many investors may reasonably ask, “But what if it’s different this time?”

To which I’d ask in response: But what if it’s not?