There’s a faint but growing sense that this bull market has gone on too long. Some people feel that we’re due for a correction. In our 3Q17 Recap, Matt put the current stock market rally in historical context. To paraphrase, geopolitical risk is always there, but we don’t think there are particular, identifiable reasons to be fearful.
On a P/E basis, the S&P 500 is trading at roughly 23.5 times trailing twelve month earnings – the historical average is closer to 21.5 times. That’s a little more expensive than average, but not terribly so. Moreover, since the stock market is a discounting mechanism for future profits, the current P/E is probably suggesting that corporate profits are poised for continuing growth.
Still, we also know that corrections have always been aspects of investing. We will have a correction, but we don’t know when or how severe it will be. History may be a useful guide. The chart below shows major stock market corrections since 1990, using the S&P 500 Total Return Index.
- Trying to time when a correction occurs is a fool’s game. In the corrections above, there was a point when the index had declined 5%, then 10%, then 15%. At those points, the unknown is whether the market will decline further. Unless you can tell in advance both when a major correction is set to start and that the current one is, in fact, a major correction, you’ll just have to ride it out.
- The time it takes to recover value from the trough to the previous peak varies. But it is always longer than the time it takes to go from peak to trough. This explains why many investors get impatient and sell before their portfolio values have recovered: it’s very difficult to be patient!
- If you’re in or nearing retirement, you should own some bonds. The disastrous scenario to avoid is to retire on March 9, 2009 (the absolute bottom), and immediately begin selling stocks to buy bonds. Peloton clients who will rely on their portfolios during retirement have meaningful bond allocations 5 years before retirement. That’s enough time to ensure their spending needs are met without having to sell stocks in down markets.
- If you don’t need to spend the money for 10 or more years, you may not need bonds. Historically, a 10-year time horizon has been sufficient to more than recover the value lost in stocks during a correction. However, if volatility makes you nervous, allocating some of your portfolio to bonds will mute ups and downs.
We see no reasons to believe that a major stock market correction is imminent. At the same time, we know that we’ll eventually have another one. Fortunately investors who get their stock / bond mix right, and who choose to be patient, will come out stronger on the other side. It’s natural to want to protect (sell) stocks from a correction, but timing markets is virtually impossible. And timing mistakes do much more damage to a portfolio’s value than entering a correction with the right asset allocations and being patient.