There’s a common saying among investors that markets take the stairs up and the elevator down. This is because the long-term trends that drive markets higher tend to be slow moving and compound over time, whereas the events that create short-term panic tend to be sudden and unexpected. At the same time, history shows that even new market lows tend to be higher than previous peaks. In other words, markets often take the stairs up several floors before riding the elevator down one or two levels. For long-term investors, understanding this dynamic in the current environment is critical to staying focused on important financial goals.
A more technical way to frame this dynamic involves the distinction between returns and volatility. Returns are simply the gains that investors experience in their portfolios which, ideally, should be measured over time frames that capture the growth in asset prices across important phases of the market and business cycle.
In contrast, volatility measures how much prices swing over days, weeks, or months. These swings often reflect the gap between reality and expectations for investors. Given that expectations can shift wildly in both directions, it should not be surprising that market prices fluctuate as much as they do. However, these fluctuations do tend to even out over time. In the end, what should matter more to investors is their final outcome and less the path it took to get there.
The past few weeks prove this point. The recent market correction, typically defined as a 10% decline from the previous peak, pulled the S&P 500 back to levels last reached in May before then spurring the strongest rally of the year during which the market gained 5.9% (as of 11-4-2023). This is because investors feared the worst when rates jumped in October before new data showed that the backdrop is more balanced than expected – one in which inflation is slowing and economic growth is steady but decelerating enough to appease Fed policymakers. Markets often need time to adjust to these dynamics which naturally causes asset prices to swing.
Market corrections are normal and occur regularly
So, what are investors to do when markets swoon? The chart above is a reminder that market corrections are normal and occur on a regular basis, in both good and bad years, and even during strong bull markets. When corrections do occur, markets often fall as much as 14% or more. Despite this, major indices have historically recovered in a few months.
What’s more important is that rebounds often occur suddenly and unexpectedly, just as they did in mid-2020, earlier this year after the banking crisis, and throughout countless other examples. Trying to time this reversal perfectly often backfires since it means missing out on the earliest part of a recovery. Of course, the past is no guarantee of the future, but this a reminder for investors to stay focused on the long run and not get caught up in short-term market movements.
Markets do not expect the Fed to raise rates again
Will the market swoons persist? The answer is unknowable but there is some good news out there for markets. The Fed decision to hold rates steady at its November meeting was likely the main driver of the recent rally after falling into correction territory. The Fed recognized that there have been important improvements to the inflation story while the overall economy has been healthier than expected. A softer labor market reading reduced the risk that inflation could surge unexpectedly, and unemployment is approaching the Fed’s 4% forecast for the end of the year. The Fed’s ideal situation is that interest rates remain high across the yield curve to keep the economy in check without the need for additional rate hikes.
This is not to say that market volatility is behind us – it never is, after all. On the contrary, it highlights that markets and investors often get ahead of themselves whether it’s due to inflation, the Fed, financial stability in China, Washington politics, or dozens of other factors. In all of these cases, it’s more important for investors to understand the bigger picture than try to react to every new headline.
The bottom line? Prudent investors should continue to focus on the big picture rather than react to daily market moves. Doing so is still the best way to increase the odds of achieving financial goals.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Data and analytics provided by Clearnomics, Inc. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article.