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Investing involves coping with two conflicting realities — especially amid pullbacks

·Contributor
·6-min read

A version of this post was originally published on TKer.co.

Investing in the stock market is a challenging mental exercise.

Among other things, investors have to cope with two seemingly conflicting realities: In the long-run, things almost always work out for the better; but in the short-run, anything and everything can go very badly.

In an environment where news headlines seem overwhelmingly alarming, I think it’s helpful for investors to see what history says about the market implications of comparable events. And as you’ll read on TKer, there’s nothing that the stock market couldn’t overcome given enough time.

HOWEVER, it can’t be reiterated enough that 5% pullbacks and 10% corrections happen more often than not in any given year. Bear markets, where stocks fall by more than 20% from their highs, are less frequent, but they are something that long-term investors are likely to confront during their investment time horizons.¹

Investing: Behind every bull is a bear lurking in the shadows. (Source: Getty Images)
Investing: Behind every bull is a bear lurking in the shadows. (Source: Getty Images)

Unfortunately, it is incredibly difficult to predict when stocks will fall. And exiting stocks in an attempt to avoid short-term losses can prove incredibly costly to long-term returns.

So, whether or not you can comprehensively identify and balance all of the potential bullish and bearish market catalysts, it’s probably a good idea to just always be prepared for stocks to experience some big dips on their long upward journey.

Pop quiz 📋

The S&P 500 is down 8.3% from its January 3 closing record closing high of 4,796. I’d bet if you were asked, you could quickly come up with a few good reasons to explain what’s behind this drawdown in prices. The Fed, inflation, supply chains, valuations, Omicron, Russia, China… those would all be good reasons.

Here’s a harder question: What was the story behind the 10% drawdowns in 2018, the 14% drawdown in 2016, the 12% drawdown in 2015, the 10% drawdown in 2012, the 19% drawdown in 2011, and the 16% drawdown in 2010?

If you’re like me, then you probably struggled to recall exactly what had the stock market so troubled during each of those periods.

The point of this exercise isn’t to suggest that the risks facing investors and the markets at those times weren’t serious.

Rather, the point is to show that pullbacks, corrections, and even bear markets happen frequently. And more often than not, they’re so short-lived that the once-unsettling risks thought to be driving those drawdowns prove to be inconsequential and quickly fade from memory.

The bottom line

Anything could go wrong at any moment, driving the stock market lower. Covid infections could get worse, supply chain disruptions could persist, tighter monetary policy may not be well received, inflation might not cool down any time soon, geopolitical turmoil could erupt, and so on. The stock market could also fall for no obvious reason.

If you’re not able to stomach short-term volatility or if your portfolio can’t handle short-term unrealized losses, then investing in the stock market might not be for you.

These short-term challenges are the price investors pay for long-term riches.

For a bit more on all of this, below is an excerpt of an exchange I recently had with a paid subscriber.

…I think there are many reasons to be concerned. (I'm adding some links below because I know there are others reading these comments.)

📉 While the data tells me the fundamental outlook looks favorable, history tells us that big drawdowns happen. Sometimes with little explanation. So I think investors should always be concerned that the next big drawdown is around the corner. More on that here: (Link)

I do think that when a lot of investors and financial professionals are talking about specific risks (e.g. inflation, Fed rate hikes, etc) that there's a good chance that much of the downside related to those risks get priced into the market. More on that here: (Link)

📉... BUT with that in mind, one of my biggest concerns is the emergence of a negative shock that few see coming. Something that's unlikely to be priced into the market, and importantly, something that businesses are not prepared for. Something that represents a material threat to earnings, because earnings seem to be the key driver of stock prices. More on that here: (Link)

🕰 I'll be the first to admit that a lot of what I write about slants bullish. But as you'll see from what I've been publishing, it's all driven by data. And there's a hundred years of data that shows that the stock market can emerge out of the worst crises IF you can give it time. More on that here: (Link)

... Because I have the ability to wait a couple of years, I'd be happy to put fresh capital in the S&P 500 right now, knowing full well there's a very strong chance I could be sitting on substantial paper losses for a while.

Some recent stock market features from TKer:

Rearview 🪞

📉 Stock market falls: The S&P 500 closed at 4,397.94 on Friday, down 5.7% for the week and 8.7% from its January 4 high of 4,818.62. Keep in mind that since 1950, the S&P has seen an average annual max drawdown (i.e. the biggest intra-year sell-off) of 14%. As Ben Carlson of Ritholtz Wealth Management recently said: “As far as how long this correction lasts, the truth is we don’t know. Bear markets and crashes are rare. If history is any guide, there is a higher probability this is simply a regular correction as opposed to the end of the world.“ For more on big sell-offs, read this.

📈 … Interest rates jump: The yield on the 10-year Treasury note jumped to 1.9% this week, the highest level since December 2019. The move comes as expectations for tighter monetary policy occurring sooner becomes embraced more broadly.

🛢 Oil prices rise: The price of a barrel of Brent crude, the global benchmark for oil, touched a 7-year high of $89.17 on Wednesday. WTI crude, which is based on U.S. oil blends, touched a 7-year high of $87.92.

😷 Out sick: According to a Census survey conducted between December 29 and January 10, 8.7 million workers weren’t working because they were either sick with Covid symptoms or caring for someone with symptoms. For more on what this means, read this.

💼 Unemployment claims tick up: Weekly initial claims for unemployment insurance have ticked up in the week ending January 15. “The recent surge in COVID cases may have led to increased layoffs, and the trend in the claims data has weakened lately around a time when some other economic indicators also softened,“ JPMorgan economist Daniel Silver wrote. Though the overall level remains relatively depressed when you consider the number of people out sick. For more on what this means, read this.

🏘 Home sales dip: Sales of previously-owned homes hit a 15-year high in 2021, though they fell 4.6% month-over-month in December amid limited housing inventory. From NAR chief economist Lawrence Yun: “December saw sales retreat, but the pull back was more a sign of supply constraints than an indication of a weakened demand for housing… This year, consumers should prepare to endure some increases in mortgage rates.“ For more on tight housing inventory, read this.

💰 Mega acquisition: Microsoft is buying video game maker Activision for $69 billion.

💰 Mega investment: Intel plans to invest at least $20 billion in building new chip factories in Ohio.

Up the road 🛣

Earnings season heats up next week with IBM, Microsoft, Verizon, Tesla, Intel, Apple, and McDonald’s among the big companies to announce quarterly financial results.

On the economic and policy front, the Federal Reserve takes center stage as it will hold its monetary policy meeting on Tuesday and Wednesday. Experts expect the Fed to signal that it will raise its benchmark interest rate at its March policy meeting.

¹ For lots of great stats on 5% pullbacks, 10% corrections, 20% bear markets and more, read Ben Carlson’s piece from Thursday.

A version of this post was originally published on TKer.co.

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