Insights & Advice

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The sun shines on the stock market

“There are three kinds of lies: lies, damned lies, and statistics.” —Unknown

Mark Twain popularized the above quote, but proper attribution is unknown. I used it last week when my colleague, Scott Little, and I were trying to figure out what it meant for stock prices now that the S&P 500 stock index had gone 200 days without a 5% correction. That’s a long stretch. Typically, there are 3-5 5% pullbacks in a year.

The phrase came to mind because it describes how persuasive numbers can bolster or weaken an argument. Scott and I each looked at this data separately, then discussed it. We found both good and bad news. Well, Scott saw the good news, and I saw the bad news.

Over the two decades we’ve worked together, Scott has tended to be more positive and, well, more often correct. I, on the other hand, am constantly a nervous wreck. All I see are ominous dark clouds. And, thankfully, I am usually wrong to be so worried. This clashing of sunshine and darkness is how we consider which investment moves to make or not make.

First, let’s set the stage. As of August 20, 2021, the S&P 500 had gone 200 consecutive days without a 5% correction. So far, in 2021, the most significant pullback has been -4.2%. Since the 1928 inception of the index, there have only been three calendar years in which the largest retreat was smaller than that -4.2%: 1995 (-2.5%), 2017 (-2.8%), and 1964 (-3.5%). It makes you wonder — are we due for a pullback? It seems so.

The numbers aren’t great when you look at the largest pullbacks in the 12 months following the last day of at least 200 consecutive days or more without a 5% drawdown. The smallest correction was a mere -6.4% in 1994. In 1996, then-Federal Reserve Chairman Alan Greenspan opined that the stock market had been experiencing years of “irrational exuberance.” The exuberance in the stock market may again be irrational enough to minimize drawdowns.

Or the stock market experiences a pullback like the average of -14.0%. (FYI, the years in the chart are only from 1957 on, as the index became more “modern” in that year, as it became comprised of 500 stocks.)

That’s me — always looking for the negative. Scott, however, sees it differently. He notes that after these long stretches when the stock market didn’t correct 5%, from 3 months to 1 year after, the average returns were flat to slightly positive. Selling stocks to avoid a correction could trigger capital gains and increase the risk in your portfolio, as you would have to be near-perfect in getting in and out at the right time.

“Snap out of it!” —Loretta Castorini

But wait. There’s more! According to Dow Jones market data, the shortest of these stretches was 210 days (ending August 20, 2015), and the longest was 404 days (ending February 2, 2018). The average was 326 days. We could have more time to go before the market begins its pullback.

But wait. There’s EVEN more! The average two-year gain after those stretches was 27.4% (17.6% for the median). And the average five-year increase was 64.0% (55.0% for the median).

I am always looking for a reason to run and hide. Duck and cover. On August 17, 2021, my company had one of our investment committee meetings. Eight of us joined in. Some in person, some via video conferencing. After 90-ish minutes of debate and discussion, we ended with an optimistic tone. We decided that no changes would be made to our equity investments. Not-so-half-jokingly, I said that if I call an emergency meeting to get defensive, tell me to snap out of it because things are looking really good.

In my defense, things looking really good is not mutually exclusive to being overdue for a pullback. It’s entirely plausible that things can continue to get better, and we could become even more overdue for a pullback. My intention isn’t to time it. Not perfectly, anyhow. But as the days tick by and stock prices tick higher, I may become incrementally more defensive. That could mean raising cash, trimming laggards, or rotating into defensive areas — whatever is appropriate for an investor’s situation and risk profile.

Whatever the tactic, it’ll likely be appropriate for something consistent with a possibly significant correction, but not the end of the bull market. My base case is that this bull market continues, for all the reason I’ve written about before: an accommodative monetary policy, massive fiscal stimulus, safe and effective COVID-19 vaccines, and pent-up consumer and corporate demand.

However, there is some weakening breadth that worries me. Stock market breadth indicators highlight the percentage of stocks in an index trading above a moving average. A stock market index can continue going higher even as individual stocks roll over and go lower. Eventually, enough individual stocks drop so that the entire index begins to stall and then decline.

Breadth for the S&P 500 peaked in April, troughed in June, improved a bit, but now has come under pressure again. The tech-heavy NASDAQ and the small-caps of the Russell 2000 have been weaker for longer. A pattern of weakening internal market conditions does not always precipitate a bear market. However, if you’re paying attention, the warning supplied by weakening conditions can often give you time to prepare.

I am holding portfolios to reflect Scott’s sunny disposition. But I am prepared to whip out my umbrella.

Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing investments of more than $700 million. Unless specifically identified as original research or data-gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable. Full disclosures. Direct inquiries: email hidden; JavaScript is required.

This article originally appeared in The Berkshire Edge on August 30, 2021.