With markets having rallied significantly over the past several months, both in the US and around the globe, we thought it might be interesting to take a look at the frequency, duration, and depth of market corrections over the past 60 or so years. We’re not undertaking the exercise in anticipation of major upcoming market turmoil. Instead, it’s a reminder that investors’ expectations for equity market performance are often romanticized on some level. Memories can be very short. Investors often underestimate the frequency of corrective episodes. In reality, it’s a normal part of the process of investing in equity markets. Over time, equity market returns have been solid. Investors just have to endure some bumps and volatility along the way. Of course, some of the bumps are a lot worse than others. As we’ve discussed in the past, the severity of corrective action is best viewed within the broader context of “secular bear market” or “secular bull market” action. These cycles generally have lasted 15 to 20 years over the past century and are generally bookended by valuation extremes; “secular bull markets” end when valuations are severely stretched, while “secular bear markets” have usually ended with long-term valuation indicators at severely compressed levels, such as single-digit P/Es.
For this exercise, we defined a correction as any peak to trough decline exceeding 15%. Because there is much more data available, we focused exclusively on the S&P 500. We took the liberty of adding the correction of 1953 in light of the facts that the peak to trough decline was 14.8%, very close to the 15% threshold, and the correction lasted nearly a full year. On to the data:
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| *Highlighted Cells represent periods during Secular Bear Markets |
From 1950 through the end of 2012, there have been 16 major corrections. Nine of those 16 corrections have occurred during secular bear markets.
This brings some interesting observations to the surface, however. While the frequency of corrections is nearly equal between secular bear and secular bull markets, the nature of those corrections is markedly different. During secular bull markets, the last of which occurred between approximately 1982 and 2000, the average length between correction troughs and subsequent market peaks is nearly 4.5 years. The longest stretch between corrections occurred during the mega-1990s bull; nearly eight years passed between the correction in late 1990 and the correction in 1998 associated with the LTCM and Russian debt default debacles. During secular bear markets (we’ve been in a secular bear since 2000), the length between corrections falls to approximately 2 years on average. Furthermore, the duration of the corrections during secular bear markets far exceeds the durations generally observed during solid market up periods. Average correction duration during a secular bear is approximately 1.25 years, with the longest peak to trough decline occurring over approximately two and a half years from 2000 to late 2002. Secular bull corrections have lasted on average a little less than half a year. Interestingly, 6 out of the 16 corrections identified here have lasted a quarter of a year or less. Finally, and probably most important to investors, the magnitude of correction declines (at least those corrections meeting our criteria) during secular bears exceeds that of secular bulls by a decent margin: 33% on average to 23%. The most devastating peak to trough decline, of course, occurred between late 2007 and early 2009. That decline of nearly 58% will remain seared in investors’ memories for quite a while.
If, back of the envelope, we total up all the calendar time from 1950 to 2012 during which investors were mired in correction, it comes out to about 14 years of market time. This represents about 22.5% of the calendar space over that time frame. Even with the volatility and deep declines investors have experienced over the past 12 years of this secular bear, it’s probably not a stretch to believe that the typical investor would probably underestimate how much time the market spends in corrective stretches (might make for an interesting survey).
A few final notes pertaining to the data: 10 of the 16 major corrections have been associated with official US recessions as dated by the National Bureau of Economic Research. As for the other six, those have generally been associated with a gut-wrenching series of negative headlines, such as the near collapse of LTCM in 1998 or the string of crises associated with the European sovereign debt crisis over the past few years. There is a statistical relationship between the starting Shiller P/E value at the peak and the subsequent magnitude of the correction, but the connection isn’t rock-solid; the r-squared is approximately 0.23 and the correlation is approximately -0.47. The average starting normalized P/E was approximately 21x, above the long-term average of 16x. Notably, four major corrections, 1953, 1976-1978, 1980, and 1980-1982 began with below average normalized P/E ratios. Matter of fact, the early 1980s corrections began with normalized P/E ratios in the high single digits.
Again, we’re not trying to scare investors here, but just pointing out that to achieve the solid long-term returns of approximately 6% per annum without dividends/9% with dividends in equity markets, you sometimes have to take a few lumps. It’s always tempting to try to time every single correction to enhance the return profile. In practice, timing the shallower corrections has proven quite difficult and even counter productive for investors. Conversely, the deep-dish declines as witnessed in 2008, 2000-2002, and 1973-1974, were generally preceded by a combination of significantly above average valuations, clear signals of impending economic recession via leading economic indicators and other metrics, and clear technical deterioration and signs of distribution in major market indices.
