The U.S. stock market turned sharply lower Tuesday morning in reaction to seemingly negative comments by the CEOs of Morgan Stanley (MS 1.00%) and Goldman Sachs (GS 0.70%). At the Global Financial Leaders' Investment Summit in Hong Kong, each Wall Street executive warned of a potential drawdown in the U.S. market in coming months.
"It's likely there'll be a 10 to 20% drawdown in equity markets sometime in the next 12 to 24 months," said Goldman Sachs CEO David Solomon. "Things run, and then they pull back so people can reassess."
Morgan Stanley CEO Ted Pick agreed that a drawdown of 10% to 15% is likely in the near term.
In reaction, the S&P 500 (^GSPC 1.12%) fell 1.2% in early morning trading before recovering some ground. Some of the stocks that have risen most rapidly in recent months were hit the hardest. Nvidia was down 2.7% at midday Tuesday, and Palantir Technologies sustained a whopping 7% drop. Consumer defensive stocks like Walmart and Coca-Cola, in contrast, were higher on the day.
Image source: Getty Images.
Should investors worry?
The question is, should investors worry about the ominous warnings of these two Wall Street executives?
The short answer: Probably not.
Corrections of 10% are extremely normal for the stock market. In fact, they're relatively common. The S&P 500 index has experienced an average annual correction of at least 10% every year since 1950. And there is a 20% correction -- usually called a bear market -- every three to five years, on average.
The market experienced a sharp correction in February-April of this year, falling 19% lower than its February all-time high. It has since recovered and posted new all-time highs.
So the warnings by Solomon and Pick really aren't all that dire. That's probably why Pick said we should welcome a 10% to 15% drop in the market: "We should also welcome the possibility that there would be drawdowns, 10% to 15% drawdowns that are not driven by some sort of macro cliff effect."
Solomon added that such a correction shouldn't really alter anyone's investment strategy.
"A 10 to 15% drawdown happens often, even through positive market cycles," he said. "It's not something that changes your fundamental, your structural belief as to how you want to allocate capital."
A frothy market
The CEOs were no doubt reacting -- at least in part -- to the fact that U.S. stocks have become very expensive this year. The Shiller Cyclically Adjusted Price Earnings Ratio (CAPE ratio) is now at 40.95, its second-highest peak of the past 140 years. That's higher than it was on the eve of the Great Crash of 1929, and just a hair below where it stood on the eve of the internet bubble burst of 1999-2000.
NYSE: MS
Key Data Points
Corrections, in fact, can be seen as very healthy. They bring some overvalued stocks back to reasonable levels based on company earnings. Corrections also present buying opportunities and new, lower entry points for investors to purchase assets. Some investors use corrections to take advantage of dollar-cost averaging. That is, they purchased a security at a high price and can now add to their stake of that stock at a lower price, bringing their average cost down.
That said, if your time horizon is very short -- less than three years or so before you'll need to liquidate positions for cash (for retirement, for example) -- corrections can be difficult. The market typically needs some time to recover from a correction and head higher.
But for most investors, I would say this: Don't worry, be happy about corrections (the Wall Street CEOs certainly don't seem too worried). Corrections and drawdowns are common, normal, and even beneficial for your portfolio and your investment strategy.
