Correction or Pullback, January’s Swings Call for Calm

If you had better things to do Monday than watch the stock market’s every tick—and we hope you did—you might think the day’s 0.3% rise signaled a pretty uneventful day.^[i] Boring, even. But that isn’t the full story. The S&P 500 began the day with a steep slide, hitting -4.0% at around 9:30AM Pacific time, as a cacophony of headlines shrieked about thousand-point Dow drops and the S&P 500 entering a correction.^[ii] (A correction is a short, sharp, sentiment-driven drop of -10% to -20%; at the low today, the S&P 500 price index was -12.0% from January 3’s record high.^[iii]) Stocks then spent the rest of the day rallying, undercutting those headlines and forcing market reporters to change their tune. Now, no one knows whether this reversal will mark the end of the year’s early, sharp pullback. Maybe it does. Maybe stocks reach correction territory in the days ahead. Regardless, we think investors’ best course of action is the same: Stay calm and exercise patience.

Magnitude aside, the downdraft to start 2022 looks a lot like a correction—and not much like a bear market. The lockdown-induced, warp-speed 2020 version aside, bear markets usually begin gradually—with long rolling tops early. As the old adage goes, bear markets typically “start with a whimper, not a bang.” They usually begin amid euphoria, with investors generally poking fun at bearish theories. And they are driven by fundamental negatives—real doozies investors either don’t see or dismiss as phony, teeing up major downside surprise when reality dawns on them.

Corrections are different. They normally begin with a bang, for any or even no reason, with stocks falling steeply from a prior high and plunging fast. Typically, they have some big fear or scare story associated with them many presume is driving the negativity. After a swift fall that has most expecting worse to come, stocks turn around and snap back higher—usually about as fast as they fell—with no warning.

Most analysts use closing prices to size up market moves. On this basis, this bull market—which dates to March 23, 2020—still hasn’t seen a correction. The biggest decline so far was September 2020’s -9.6% pullback.^[iv] But regardless, January 2022’s move—magnitude aside—has many of the features we would expect of a correction. The last record high was on January 3, with a steep slide since—the “bang” typical of corrections. Sentiment when it started wasn’t euphoric, as many investors fixated on an array of worries. And it seems to have twin stories many allege are “driving” the drop—Russia/Ukraine tensions and rising interest rates.

In our view, time and patience should prove both false. Obviously, if Russia invades Ukraine, that isn’t good news. But markets have seen many regional conflicts over the years, and they don’t normally trigger bear markets. We showed you a selection of these in November when Russian sabre-rattling started perking up. Sadly, regional conflict—like Russia seizing Ukrainian territory in 2014—is commonplace. It is a human tragedy, of course. And fear over the impact can stoke short-term volatility, normally before any actual conflict, as markets pre-price war worries. But market cycles usually aren’t impacted by conflict unless it has the scope to greatly disrupt global commerce. Should conflict between Russia and Ukraine erupt, we don’t think it would have anything approaching that power.

As for rising interest rates, they have commanded investors’ attention this year, and fears over their impact have likely contributed to the regression in markets this January. That said, a longer-term look at fundamentals shows the notion rising interest rates are terrible for stocks is bogus. Over the past 20 years, the weekly correlation between the S&P 500 and US 10-year Treasury yields is 0.33.^[v] Identical movement is 1.00 and -1.00 means exact opposite, so that positive number means stocks and bond yields move together somewhat more often than not. You read that right. Rise and fall together more often than not. It isn’t a strong correlation, which means periods where they diverge aren’t hugely unusual. But this is a solid reason to question common theories of rising yields killing stocks. Tech? The correlation with yield moves is positive, too.

As for Fed rate hikes, stocks normally rise following the start of tightening cycles, too. Heck, there were two separate tightening cycles in the 1990s bull market. One in 2002 – 2007’s cycle and one in 2009 – 2020’s cycle. The first hike in each came long before stocks peaked.

We strongly doubt interest rates have a lasting impact on stocks—if they even keep rising. Given the near-universal view rising rates and inflation threaten this bull market, markets have likely pre-priced these opinions and seem set to surprise by proving them incorrect.

Corrections are an example of the fact markets can be irrational in the short term. But in the longer term, rationality—and fundamentals—normally win out. Today, data like purchasing managers’ indexes and The Conference Board’s Leading Economic Index suggest continued economic growth ahead, which should support firms’ earnings. We have US midterm elections this year, which—if history holds—should deepen gridlock and kick off the most bullish stretch of the US political cycle. Sentiment was sour entering 2022 based on Omicron, geopolitical tensions and all the false fears about the Fed. That suggests to us positive surprise is likely as this year progresses—fuel for this bull market to persist.

We don’t know exactly when the recent bout of negativity will end. Maybe it already has. But it looks to us very much like a passing, sentiment-driven event. In our view, that calls for investors to take a longer view and refocus on fundamentals.