Economic News & Analysis—June 3, 2013

How inevitable is a market correction?

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

Do markets correct every three years? More often than not, they don’t.

The S&P 500 Index ended May at 2.3% off its all-time high of 1,669, which was set a mere 10 days earlier. Some investors have probably been thinking that the market has run too high, too fast, and they are waiting for a 5% to 10% pullback before jumping in. Of course, they probably started saying that 20% to 30% ago. In the effort to avoid a 5% to 10% loss, they gave up 20% to 30% in gains.

This is not to say that a market correction of 5% to 10% won’t happen, but it’s not inevitable. As we’ve argued before, we think the equity market is going through a long-term market correction, but a correction to the upside, not the downside. Perhaps it will seem richly valued if we go above 1,720 before the end of the year, but even at that level, stocks would look attractive for those with investment horizons of three years or more instead of three days or less.

One statistic that some media outlets have thrown out there is that the market declines 5% to 10%, on average, every three years, and that we are overdue for a correction. This claim is an example of a bad use of statistics.

I looked at the daily closing values of the S&P 500 Index since January 5, 1950, and measured how long it took before the market went down 5% or 10% from any given day. For 54.3% of the days, I found no 5% correction. For 69.3% of the days, I found no 10% correction. In other words, if you invested on any random day, you would have had less than a 45.7% chance that the S&P 500 Index would have gone below 5% lower than you started and less than a 30.7% chance that the market would have gone 10% lower than you started. In other words, there is nothing inevitable about there being a market correction.

When there were corrections, the average time it took to drop 5% was 2.97 years and the average time it took to drop 10% was 3.16 years. Properly, the media should be reporting, “Assuming that there will be a correction, it will typically take around three years to happen.” That’s different than saying that corrections happen every three years. They don’t. More often than not, corrections don’t happen.

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