Is it Over? Five Misconceptions About Corrections

by Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• The worst of the current global stock market correction may be over, but it is unlikely to be the last one this year.
• There are a lot of misconceptions about what signals the end of a correction.
• Unfortunately, there aren’t simple rules to follow that work every time to call the bottom.

Is the decline in stocks over? Although stocks have recovered nearly half of their peak-to-trough losses this year, it is still too early to tell what comes next when looking at price performance of this pullback compared to past bear markets and corrections in the MSCI World Index since 1979, as you can see in the chart below.

Too soon to tell

Source: Charles Schwab, Factset data as of 2/16/2018.

The market’s decline does not appear to be the start of a typical bear market. Bear markets, the term for a decline of 20% or more, are most commonly associated with economic recessions. There is currently no sign of a downturn in global economic data or in leading economic indicators like the yield curve or financial conditions. In fact, the market slide was driven by fears of the global economy overheating from too much growth, rather than too little.

So, this decline is most likely a correction, the often-used term for a 10%-20% decline. It is called a "correction" because it corrects an overshoot and returns prices to their longer-term trend—in this case correcting the sharp upward move in global stocks which began around Thanksgiving.

Misconceptions

The worst of the current correction may be over, but it is unlikely to be the last one this year. So what ends a stock market correction? Unfortunately, there aren’t simple rules to follow that work every time. Let’s look at five misconceptions about what ends a stock market correction:

1. Size or Duration – Stocks tend to pullback an average of 15% each year from peak-to-trough, measured by the MSCI World Index since 1979. But that’s just the average. Corrections range widely in their depth and duration, offering investors little signal as to when they have run their course.

2. The Fed “put” – Some believe that the Federal Reserve, along with other central banks, have a target for equity markets, that they won’t allow stocks to fall below a certain level, as if they offer investors a “put” option. The last correction in early 2016 saw a quick trim in the outlook for Fed rate hikes; the fed funds futures market quickly erased for two of the three rate hikes expected over the next 12 months, as you can see in the chart below. But that market decline was driven by fears of economic weakness, justifying support from monetary policy. But the current correction has been driven by fears of an overheating economy leaving little justification for a central bank “put.” In contrast to early 2016, fed fund futures so far this year have priced in the probability of even more rate hikes on top of those already expected over the next 12 months, as you can see in the chart below.

2016 correction eased Fed rate hike expectations, 2018 correction saw the opposite

Fed Funds rate future reflects the futures market expectation for where the Federal Reserve’s policy rate will end the year. Source: Charles Schwab, Bloomberg 2/15/2018.

3. Fair valuations – A common refrain heard during corrections is that stocks need to get back to “fair value” before they stop going down. Setting aside what a subjectively determined “fair value” might be, history shows us that corrections are not consistent in the price-to-earnings ratio they stop at (which has ranged from 11 to 33 for corrections since 1979) or how far valuations decline before they stop (ranging anywhere from 0.3 to 6.6 points). If it were that easy we could simply determine whether the recent decline in global stock market valuations to the lowest level in two years and valuations of non-U.S. developed stocks to near the lowest level in four years was enough to end the correction, as you can see in the chart below.

Stocks now have the lowest valuations in years

Forward price-to-earnings ratio uses next twelve month earnings per share estimate.
Source: Charles Schwab, Factset data as of 2/14/2018.

4. Moving averages – There is logic in believing that markets need to revert back to their price trend after an overshoot. Technical market measures like moving averages are thought to act as price support for a falling market. However, there isn’t a consistent moving average that has always acted as a floor for the stock market during corrections. Stocks usually fall below the often-cited 200-day moving average.

5. A change in the data – When markets respond to a weakening economy, signs of a turnaround in the data can ease investor concerns and provide support to stocks. However, as noted in #2 above, this correction is different. Market participants are not looking for the strong economic data to change direction. They are looking for a change in the degree of growth as they grapple with how much growth is too much. Discerning a subtle change in degree of growth, rather than a sharp change in direction can be more challenging and may not act to end a correction.

No simple rules

History shows that corrections in bull markets are common, especially during the last few years of the economic cycle when they have averaged two or three per year. Unfortunately, there aren’t simple rules to follow that work every time to signal the end of a correction. This implies that long-term investors would benefit more by letting the correction run its course than trying to call a bottom.

Perhaps there may be one indicator to watch to help answer the difficult question plaguing the stock market of how much growth is too much growth: the dollar. Since the U.S. is among those nations seeing better growth and is at risk of overheating, using the dollar as a barometer for global growth and inflation trends may be worthwhile. The dollar benefits from faster growth, but not from inflation. This is different than interest rates, which go up in either case. But even this signal isn’t without noise. It is possible that growing U.S. trade and budget deficits are weighing on the dollar, rather than inflation.

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