Reflections on corrections

One Fidelity expert looks to past corrections for clues to today's opportunities.

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Key takeaways

  • Since 1960, there have only been 10 corrections in the US stock market as steep and fast as the pullback in February, which had a 10% decline in 9 trading days.
  • Historically, stocks have generally performed well after such sharp corrections, with positive 12-month returns following 8 of the 10 corrections, and an average gain of 17%.
  • Looking back to 1955, the market has had better odds of an advance when interest rates are rising rather than falling.
  • Many corporations still seem relatively early in their profit cycle, which has been positive for cyclical sectors in the past.

It had been clear sailing for months—years, really. Global stock markets had been setting fresh all-time highs, with volatility at record lows.

And then, in what appeared to be a storm cloud bursting out of the clear blue sky, stocks plummeted in early February, erasing all of 2018's gains in the span of just over a week. All told, US stocks had their worst week since October 2008, then rebounded sharply a week later only to be set back again on fears of a trade war.

To gain some historical perspective on pullbacks, Viewpoints interviewed Fidelity Sector Strategist Denise Chisholm. Chisholm looks for patterns in market history, using historical probability analysis. She points out that while corrections are normal, the February occurrence was unusually sharp—but that steep corrections historically haven't been bad for future returns.

She also notes that many corporations still seem to be relatively early in their profit cycle, based on historical patterns, which suggests that the stock market may be resilient in the face of recent pullbacks. Such periods have benefited cyclical sectors in the past.

While past performance is not a predictor of the future, it can help frame your analysis of the current market environment and potential opportunities ahead.

The market in early February dropped 10% in just 9 trading days. How common are those types of pullbacks?

Chisholm: Looking back to 1962, 60% of calendar years have included peak-to-trough corrections from 5% to 15%. In that sense, the current correction is normal and maybe even healthy. I reviewed the 12-month returns following those previous corrections and found that their average return was similar to the market's long-term average annual returns.

That said, the steepness of the February pullback was somewhat unusual. A correction this sharp, with a 10% loss in 9 trading days, has happened only 10 times from 1960 to 2018—about once every 5½ years on average. It’s interesting to note that the market has generally performed well following those sharp corrections, with positive 12-month returns 8 out of 10 times, and an average gain of 17%.

Historically, stocks have done well, on average, after pullbacks.

The conventional wisdom says that the February sell-off happened after investors got spooked by the combination of high valuations and rising interest rates. How have stocks responded to high valuations and rising rates in the past?

Chisholm: I think most investors assume that falling interest rates have been better for the stock market than rising rates. But, in fact, looking back to 1955, the market has had better odds of an advance when rates are rising than when rates are falling. The reason for that seems to be that rates tend to rise when the economy is healthy, and a healthy economy is generally good for the market. So, historically at least, increasing interest rates do not by themselves indicate weakness in the stock market.

What about valuations? It's true that valuations in the stock market are high by historical standards. Even after the correction, I calculate that stocks overall are in the 85th percentile of their historical valuation range, based on their price-to-trailing-earnings ratio. Put another way, this means that stocks have been more expensive than they are today only 15% of the time.

That said, valuations at these levels haven't had a statistically significant correlation to below-average returns over the subsequent 1 to 3 years. Historically, at these valuation levels, there has been a wide range of outcomes for the overall market and for individual stocks over the subsequent year. That may present active managers the opportunity to add value through selection of individual securities.

What factors are you watching based on your analysis of past market performance?

Chisholm: I'm keeping a close eye on the corporate profit cycle and the credit cycle.

There has been a relatively high correlation between corporate profit growth of higher than 5% and strong stock market returns. Corporate earnings are growing steadily now. That follows a profit recession in 2016, when corporate earnings fell 10% to 15% in the US and even more internationally. The contraction in profits in 2016 coincided with a peak-to-trough correction in the S&P 500 of 15% from 2014 to 2016, putting US and international stock markets in bear-market territory. The current environment is quite different. We're entering our second year of a profit recovery, which has been associated with US stock market advances.

Profit cycles historically have lasted from 2 to 6 years. The factor most associated with the length of the profit cycle has been the health of credit when corporate profits began recovering. Generally speaking, the healthier credit has been, the longer the profit recovery has lasted.

The current profit recovery began with a very healthy credit picture, as measured by metrics such as the percentage of nonperforming loans to bank assets and consumer delinquencies as a percentage of consumer loans. That said, if credit conditions were to deteriorate, they could undermine the recovery in corporate earnings. If a situation like that developed at recent high valuation levels, it might be problematic for the market.

What do you think that historical analysis suggests about the outlook for different sectors?

Chisholm: I think it implies that certain procyclical sectors may have higher odds of outperformance. They include financials, technology, industrials, and consumer discretionary.

These sectors were leading the market prior to the pullback and kept leading during the correction, so their valuations relative to the rest of the market increased. That said, according to my analysis, their relative valuations haven’t gotten to the point that historically made them statistically less likely to outperform. And, being procyclical, they would be expected to lead when investors anticipate good economic and earnings growth.

What's more, based on my analysis, these 4 sectors all have fundamental drivers that historically have been associated with strong relative returns:

  • Financials—potential loan growth
  • Technology—leading indicators that suggest expanding margins
  • Industrials—likely increases in investment spending
  • Consumer discretionary—tax cuts

Part of a bigger picture

Of the defensive sectors, health care looks interesting from a historical basis. For the first time since 1993, the sector’s relative value and relative earnings growth are both near historical low points. Looking back through history, health care has outperformed the market 70% of the time during periods after these metrics trough simultaneously.

But keep in mind that an approach like this requires research and the active monitoring and management of your portfolio. If you don’t have the will, skill, or time to do this on your own, it's probably better to seek out professionally managed investment products and solutions. For most individual investors, the most important thing is to determine an appropriate asset allocation—how your assets are split among stocks, bonds, and short-term investments—that reflects your time horizon, financial circumstances, and tolerance for portfolio volatility.

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