Study stock market history and you will understand that volatility is the price investors pay to accumulate wealth in the long term. Just like there are “no free lunches” in the real-world, in investing there is no reward without the occasional volatility or risk. However, most amateur investors make the mistake of getting overleveraged at the exact wrong moment or suffering from recency bias. Too much leverage can force an investor to be blown out of positions or worse, suffer a margin call. Meanwhile, recency bias, which involves investors allocating too much weight to the recent past, can cause investors to lose the forest for the trees.
How Common is a 5% Correction in the S&P?
Because bias can get in the way of successful investing, investors should rely on historical data to form their opinions about potential future outcomes and the current market. According to data from Carson Investment Research and Ned Davis Research, a mild correction (defined as a 5% correction or more) occurs 3.4 times a year on average.
Image Source: Carson Investment Research, Ned Davis Research
The S&P 500 Index just swooned 8.49% for its second 5+% correction of the year (the other one occurred in April). In other words, the though the recent correction may seem painful, 2024 has actually been less volatile than the average year. Furthermore, the S&P has already gained more than 12% for 2024, higher than its average of ~10% since 1950.
What is the VIX Telling Us?
The Volatility Index or VIX is a measure of fear on Wall Street. VIX just saw its third-largest spike since 2000 (only behind 2008 and 2020). Historical data strongly suggests that large spikes followed by rapid declines lead to strong returns one year forward. The VIX just witnessed its largest 4-day percentage decline (-47.2%) since 1990. Data from Charlie Bilello of Creative Planning (@charliebilello) shows that the top 20 largest 4-day VIX declines have led positive forward S&P 500 total returns in every instance.
Image Source: Charlie Bilello, Creative Planning
Have Stocks Bottomed?
Markets have humbled me enough over the years to a point where I like to say that my investing framework is about interpreting data rather than trying to predict the market’s every move. Large VIX spikes like the one we just witnessed almost always mean a long-term bottom is on the horizon. However, Bilello’s VIX data shows that in roughly half the instances mentioned above, S&P returns are negative one month later. Furthermore, U.S. equities peaked in late July and bottomed in October. A historical seasonality chart from Jeffrey Hirsch (@almanactrader) suggests that the election year seasonal pattern suggests that the late October bottom in equities is the most likely path.
Image Source: Hirsch Holdings Inc.
Stocks to Watch for Market Clues
Investors should monitor the S&P 500 Index ETF ((SPY - Free Report) ) and the other major indices to see how they react at their 200-day moving averages (the best long term trend filter).
Image Source: TradingView
Second, investors can watch the VIX or the ProShares VIX ETF ((VXZ) ) to get an idea of whether volatility is creeping back into the market. Each have fallen back to their breakout zones but if buyers’ step in this week it may be a sign of more short-term volatility in the near future.
Image Source: TradingView
Meanwhile, on the tech side, the fastest growing and best performing names have come from names in the Semiconductor ETF ((SMH - Free Report) ) like Nvidia ((NVDA - Free Report) ). After a snap back rally last week names like NVDA are into short-term trendlines resistance. A failure at these levels may mean a retest of the August lows is likely.
Image Source: TradingView
Finally, investors should be following the action in defense names such as Northrop Grumman ((NOC - Free Report) ). NOC shares are up nearly 15% over the past month while most stocks are down. Over the weekend a news broke that a Ukrainian nuclear power plant was set on fire. Though black swan events are unpredictable by definition, recent global war escalations suggest that the most likely culprit for one would come from the geopolitical realm.
Summary
Though the recent correction in equities is painful for most investors, historical data illustrates that it is inline with historical norms and a long-term low is likely within the next few months. Nevertheless, evidence shows that there is reason to dive in slowly and be cautious in the short-term.
