Last year was probably a bit too good to be true for investors. Despite an average annual return of 7%, inclusive of dividend reinvestment and when adjusted for inflation, the broad-based S&P 500 (^GSPC 0.61%) and nearly 122-year-old Dow Jones Industrial Average (^DJI 0.26%) soared about three times as much. In fact, there was hardly any downside movement, which led to the coining of the term "melt-up" to describe 2017.
But as we all know, the wheels fell off the wagon this year. In took just 13 calendar days for the Dow and S&P 500 to move from a record-closing high to more than 10% down from that high, signifying their first correction in more than two years. It was also a wake-up call to investors that the stock market can and will move in both directions.
Image source: Getty Images.
Why are stocks dropping?
There certainly have been no shortage of concerns weighing on the market. In recent weeks, investors have been perturbed by the possibility of an escalating trade war between China and the United States. Following President Trump's announcement of tariffs on steel and aluminum, China responded with tariffs of its own. An escalating trade war has the potential to hurt the global growth that U.S. multinationals have come to rely on.
Additionally, investors worry about the American economy overheating. The unemployment rate is at 4.1%, which is its lowest level in more than 17 years, and the Federal Reserve is in the midst of a monetary tightening period that could see rates rise by 75 basis points per year. Generally, higher interest rates curb lending and thusly slow growth for businesses.
Even computer trading has been partly to blame. The nearly 1,600-point intraday plunge in the Dow on Feb. 5, 2018, its largest intraday move in history, had elements of a flash crash, according to Dennis Debusschere, head of portfolio strategy at Evercore ISI, per Bloomberg.
When put into the proper context, this "crazy" statistic isn't so crazy
Yet it's not the correction that's necessarily caught investors by surprise as much as the spike in volatility over the past two-plus months. Since the beginning of February, the Dow Jones Industrial Average has logged nine of its 40 largest single-day point swings in history, or 22.5%. You can see them highlighted below.
Data source: Wikipedia, The Wall Street Journal. Table by author. Green and red highlights signify top 20 single-day point swings in 2018.
Some would view this volatility as downright crazy and borderline worrisome. However, longer-term investors who are able to put this correction into its proper context are liable to see things a bit differently.
What you'll note from the Dow's 20 biggest single-day point gains and declines of all time is that each and every one of the 2018 entries has a relatively benign percentage move attached. Sure, a 4% decline in the Dow isn't exactly something we see often, but it's nowhere near the 6.98% downward move needed to simply tie the 20th largest percentage decline of all time. Similarly, a 669-point move in the Dow might sound like a reason to uncork the champagne, but it was only a 2.84% move higher by that day's end.
The point here is that your assessment of moves in all of the major indexes, be it the Dow or S&P 500, needs to adjust along with the index itself. Over the past nine years, the bull-market rally led to a quadrupling in these indexes. While a 100-point move in the Dow might have been somewhat breathtaking in 2009, it wouldn't even equate to a half-percent decline today. That's the importance of context.
Image source: Getty Images.
Speaking of context...
While we're on the subject of context, how about taking into account some bigger-picture data?
Market analytics firm Yardeni Research has a copious amount of data concerning every correction in the S&P 500 since the Great Depression. It allows investors to pinpoint the length of a correction, as well as how far the broad-based index fell, in percentage terms. Of course, it's worth reaffirming the obvious: We'll never know ahead of time with any accuracy when a correction will occur, how much lower one will take an index, or even what will cause it.
However, we can pull an important piece of data from Yardeni's lengthy research data -- namely, the stock market spends far more time in expansion mode than it does declining. In fact, since 1950, the S&P 500 has spent in the neighborhood of three times as many days in a bull market as it did in a correction or bear market.
Furthermore, with the exception of the current correction, each and every downdraft in the S&P 500 has been completely erased by a bull market, often within a matter of weeks or months. That's the type of context that should make long-term investors very happy about their current buying opportunity.
