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Why Fears of a Market Correction Are Overblown

By Alex Dumortier, CFA - Apr 16, 2013 at 7:07PM

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The recency effect takes over.

On the heels of the worst daily performance since Nov. 7, stocks rebounded today, with the S&P 500 (^GSPC 0.95%) and the narrower, price-weighted Dow Jones Industrial Average (^DJI 0.60%) gaining 1.4% and 1.1%, respectively.

As the market found its nerve, the VIX Index (^VIX 0.00%), Wall Street's fear gauge, which had shot up 43% yesterday, fell back nearly 20%. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

Is a correction coming?
The poll on the front page of Yahoo! Finance today plumbed the market's psychology, asking: "Do you think a correction on stocks is on the horizon?" Here are the results as of roughly 6:25 p.m. EDT, with nearly 75,000 respondents:

  • Yes, it's coming: 54%
  • No, we have more room to run: 20%
  • I'm not convinced either way: 26%

A majority of investors expect a correction! I think there is good reason to believe this result is heavily influenced by yesterday's 2.3% decline in the S&P 500, due to a psychological effect that goes by the name of "recency effect" or "recency bias," according to which people put a heavier weight on the most recently available data -- in this case, a sharp one-day decline in stock prices.

It would have been interesting to see the results of the same poll as of last Friday -- my guess is that the number of people expecting a correction would have been substantially lower than 50%. If you accept that hypothesis, the question then becomes whether Monday's events require a fundamental reappraisal of that risk -- I don't think they do. Either way, the table below shows the average performance of the S&P 500 over the three-month, six-month, and one-year periods following a one-day decline greater than yesterday's (of which there have been 235 occurrences since Jan. 1950):

 

63 Trading Days (~ 3 Months)

126 Trading Days (~ 6 Months)

252 Trading Days (~12 Months)

Average % Return, S&P 500

3.5%

6.5%

11.8%

Bottom Quintile Cutoff

(4.3%)

(6%)

(8%)

Author's calculations, based on data from Yahoo! Finance.

I'm not expecting a correction, although, naturally, I can't rule it out. Equities are volatile and they've had a tremendous run. Even if they do correct, investors who are invested in high-quality franchises at reasonable valuations have time on their side and need not be concerned.

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Stocks Mentioned

Dow Jones Industrial Average (Price Return) Stock Quote
Dow Jones Industrial Average (Price Return)
^DJI
$32,120.28 (0.60%) $191.66
S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
^GSPC
$3,978.73 (0.95%) $37.25
CBOE S&P 500 Volatility Index Stock Quote
CBOE S&P 500 Volatility Index
^VIX
$29.45 (0.00%) $0.00

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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