Recovery Caps Off the Regression

US stocks hit fresh 2023 highs in price-only terms Friday, bringing year-to-date returns to 19.7% and officially ending the late-summer correction.^[i] Global stocks closed the day less than one percentage point from the same feat. As usual, sentiment turned on a dime. There was no all-clear signal. No warning. No identifiable fundamental shift. The V-shaped recovery went largely unnoticed for the first few weeks. This is how markets work, and it is why we counsel staying patient through the wobbles.

As corrections go, this one was mild. Its magnitude was -10.3%, just barely eclipsing the traditional correction threshold of -10%, and it lasted a mite less than three months.^[ii] Both are below the average for S&P 500 corrections since 1925, -14.2% and 3.2 months.^[iii] Long rates, which endured a sentiment-driven spike alongside stocks’ drop, have also fallen fast, with 10-year US Treasury yields down from their year-to-date high of 4.99% on October 19 to 4.22% Friday.^[iv] This tandem freakout and recovery is noteworthy because the primary underlying fear—higher-for-longer Fed interest rate policy—hasn’t gone away. Pundits continue dissecting all Fed statements for any possible hint that rate cuts might come next year, and they keep coming up empty. But markets seem to have priced the fear and moved on.

This brings to mind a point one of our first-class frequent readers has asked us to pass on—and since, like Vegas Air in the semi-classic movie The Wedding Singer, we let our first-class readers do pretty much whatever they want—we happily do so: It is a bit weird to even call this, or any bull market pullback for that matter, a correction. The euphemism exists because of the presumption that they happen when sentiment shoots too far, too fast and needs a bit of a poke to come back to earth. Ergo, sentiment “corrects.” But the vast majority of the time, corrections happen because some big fear captures the zeitgeist, sending sentiment quite far—irrationally, you might say—below reality. As our reader observes, using the term “corrections” in this context therefore seems quite wrong, as it implies the downturn was, well, correct. But if it was an overreaction to a false fear, “correct” seems a misnomer. Our reader suggests “regressions” as a more accurate alternative, and if we had the power to make that term a thing, we surely would. Alas, we lack that kind of clout.

This pullback surely acted like a regression. Fundamentals weren’t markedly worse in August, September and October. Actually, we now know the US economy was accelerating somewhat during this stretch, with Q3 GDP growth clocking in at 5.2% annualized.^[v] (Now, that headline rate overstates things somewhat, but growth was fine regardless.) We had twin government shutdown standoffs, but considering no shutdown ever caused a bear market and both standoffs resolved in time, we don’t see them as fundamental political risks. Interest rates? Higher long rates temporarily re-steepened the yield curve, which in any other universe is considered a good thing. Gas prices spiked ever so briefly—fanning inflation fears for a hot minute—but they quickly reverted. The Fed stayed on pause, with only its forecasts changing—forecasts that aren’t worth the paper they are printed on, as the last two years illustrate quite well. Meanwhile, all that changed in November was that a range of economic indicators slowed down.

If you read the prior paragraph and think none of it makes logical sense in explaining the steep regression and recovery, well, you are right. That is the point. Stocks’ short-term behavior often defies basic logic. Sort of like the human emotions that drive the day-by-day wobbles. This is what Ben Graham meant when he famously quipped that the stock market behaves like a voting machine in the short term and a weighing machine in the long term. Short term, stocks’ popularity vacillates on investors’ feelings, their heat-of-the moment reactions to headlines. Sometimes those are uppy feelings, and sometimes they are down feelings. (There is also a lot of noise from traders using various systems and algorithms.) But long term, all that feeling nonsense tends to even out in the weighing of fundamental reality. The scales pre-price how reality over the next 3 – 30 months is likely to shape up relative to expectations, and when you reflect back on market history, you can see it is uncannily correct.

This is why keeping a longer perspective is so important. Focusing not on what stocks do today, but on what they are likely to do over the next year or two based on the fundamental economic and policy landscape (and how those compare to sentiment surrounding them). If a bull market looks likely to continue over that foreseeable future, then it is generally best to stay invested through the turbulence. Reacting to the wobbles can mean trading in and out of the market at the wrong times, locking in losses and missing rebounds. Staying calm through the wobbles isn’t fun during the wobble itself, but it is the only way we know to reap the rebounds and stocks’ overall long-term bull market returns—returns necessary to support things like cash flow in retirement.

As for what comes next, we will share our 2024 forecast in the coming weeks. But it is worth noting, for now, that since 1925, S&P 500 price returns from a correction’s … err, regression’s low average 25.2% over the next 6 months and 33.1% over the next 12.^[vi] Averages don’t predict, and they are made up of extremes, but this illustrates the overwhelming tendency for stocks to storm back and roar higher after temporary lows. They have done the storming back, but we think there is still plenty of room to roar and run.