Q&A About the Stock Market Correction

The dramatic plunge in the stock market on Thursday, and the whipsaw ups-and-downs in the market on Friday, have raised anxiety levels for all investors. After months of relatively calm waters for stocks, volatility returned with a vengeance in May and has reached a crescendo in recent days. Many investors read the headlines and feel paralyzed about the best course of action. Stay in? Bail out? There are plenty of talking heads in the media on both sides of that debate, and either argument can sound compelling at any given time.

At times of maximum stress in the market, it is always helpful to take a step back and try to see things from a more level-headed perspective. In that spirit, we offer the following series of questions and answers that, we hope, will help you gain some perspective about the recent downturn in the stock market.

Q: Are we going into a bear market?
A: There’s no way of knowing in advance whether a stock market downturn like we’ve experienced in recent weeks will turn into a full-fledged bear market (defined as a decline of 20% or more). But if that were to occur, it would not be an unusual event for stocks. Like it or not, market downturns are part of the bargain with stock investing, happening more frequently than most people realize. Going back to 1900, the Dow Jones Industrial Average has experienced bear markets 32 times, or about one out of every three years. The average decline has been about 30%, and the average length of a bear market is about a year at 367 days.

In any event, given the long, dramatic climb stocks have experienced coming out of the 2008-09 financial crisis, it would be easy to make the case that a bear market is overdue. Consider the cumulative returns since the market low of March 9, 2009 through July 22, 2011, for the following asset classes:

• Large U.S. stocks (S&P 500)
• Small U.S. stocks (Russell 2000)
• Large International stocks (MSCI EAFE)
• Small International stocks (MSCI EAFE Small Cap)
• U.S. REIT stocks (Dow Jones REIT)
• International REIT stocks (Dow Jones Intl REIT)

Consider the magnitude of these gains. Large U.S. stocks have doubled since their 2009 lows, and small U.S. stocks have gained about 150%. Meanwhile, U.S. REIT stocks have soared nearly 250%!

Stock gains don’t continue unabated forever, of course, so from this perspective a market downturn is not only not surprising – it is actually to be expected.

Q: So if we know a bear market is coming, why don’t we “do something”?
A: Bear markets may be common, but they are hardly predictable. Many times downturns that appear to be the start of a true bear market end up running their course in fairly short order, and a long upward rise in the market soon resumes. This has happened several times this year alone. Also consider the fact that, since 1940, the average bull market has lasted more than 1,600 days – more than five years! Within these long, upward cycles are many moves downward by the market that may appear to be more significant than they really are. And even full-fledged bear markets sometimes run their course in a matter of weeks or months.

While it may be tempting to move your money out of the market, such moves just lead to further difficult decisions down the road. As the saying goes, “They don’t ring a bell at the bottom of a bear market,” meaning that there is no clear indication of when to get back into stocks. And since stocks usually take off dramatically following the end of a bear market, missing those early days and weeks can be devastating.

For example, the end of the 2008-09 bear market in March 2009 came with a relative whimper, with the Dow declining 79 points to bottom out around 6500. From that point forward, stocks took off and did not look back for nearly six months, with the S&P 500 soaring more than 50%. Investors who missed just the first week of the rebound missed out on a gain of more than 10%!

This unpredictability makes it impossible for investors – professional and amateur alike – to consistently beat a “stay invested” approach by trying to time the market.

Q: But isn’t it different this time?
It’s always “different this time.” As we mentioned in our Investment Insight about the debt ceiling issue last week, every crisis has its unique set of circumstances, which is why the stock market struggles, in the short term, to make sense of it. Interestingly, however, there are many parallels in the current European debt crisis to events that occurred more than a decade ago in Russia, and it’s worth revisiting that period of time as an historical lesson.

In 1997, a protracted currency crisis in Asia led to a chain of events that ultimately caused a crash in commodities prices. By the summer of 1998, oil-dependent Russia was teetering on the brink of default, unable to cover its government debts due to a crash in oil prices, which were hovering around $8 a barrel. Stocks began to head steadily lower as nervous investors fretted about the possibility of “contagion” in the global markets should Russia default. Those fears were realized in mid-August, when Russia succumbed to market forces and defaulted on its debt. The country’s stocks, bonds and currency collapsed, and panic swept the world stock markets. The S&P 500 plunged more than 12% the last week of August 1998, including a staggering 7% drop on August 31.

But that wasn’t all. In mid-September, famed hedge fund Long-Term Capital Management was revealed to have had huge positions in the Russian markets that had gone sour. The fund, which had deep ties to all of Wall Street’s large investment banks, announced losses of nearly $4 billion, all incurred in a month’s time. The Federal Reserve was forced to step in and broker a deal with the Wall Street banks to prop up the fund and keep its losses from spiraling through the financial system.

By October 1998, U.S. stocks had seen their gains for the year evaporate into thin air. The S&P 500 index had fallen 14% since the turmoil in Russia began, and the Russell 2000 index of small stocks dropped almost twice that amount, plunging 25%.

The bull market was over, many pundits said. It was time, investors were told, to “move to the sidelines” and “get liquid.” But then, just as dramatically as the downturn began, it ended. With all the bad news already priced in by the market, an unexpected rebound began in November. Over the last two months of the year stocks recovered all of their lost ground and more, gaining about 30% during the last eight weeks of the year:

For the round trip – from the beginning of the crisis in Russia through the end of 1998 – the S&P 500 finished up more than 10%. At the end of it all, the S&P 500 finished 1998 with a 20% gain, but many investors experienced losses for the year because they bailed out during the downturn.

Whether the current crisis resolves itself in similar fashion is, of course, unknowable. But it’s at least clear that events that seemed similarly earth-shaking in real time in 1998 resolved themselves in surprisingly short order.

Q: But things just seem so dismal with the economy. What reason is there to believe in stocks right now?
A: It is important to separate macroeconomic short-term events, like the current debt crisis, from the long-term fundamentals of stock investing, which are essentially about corporate profits. And while economic events can and do impact corporate profits, they are not always as intertwined as they seem. Just consider this collection of headlines on the Wall Street Journal’s web site, all from yesterday:

• Dow Plunges 500 Points In Global Rout
• ING Profit Rises 24%
• Stocks in Correction Territory
• GM Profit Jumps 89%
• As market plunges, fear rules the day
• LinkedIn Profit Jumps

Companies are often much more adept at navigating difficult waters and finding a way to continue to be profitable than may seem apparent. So even though the economic environment, in the short-term, may seem dicey and unpredictable, that doesn’t mean that corporate profits, in the long-term, are doomed.

The bottom line is that being a disciplined, buy-and-hold investor may seem simple - and in some ways it is - but it is certainly not easy. Like everything else in life, we are not rewarded as investors for sitting still in the easy times. It is enduring the tough, emotional times such as we are currently in that makes us our money as stock investors.

This is precisely why the flighty masses who flee for the exits when things seem the worst are the same people who never make any money in the stock market.

As J.P. Morgan said famously in 1918: “Bear markets are when stocks return to their rightful owners.”