“This too shall come to pass” –ancient Persian parable
The S &P 500 closed down 20% from its peak of 4800+ over the past 5 months. Financial headlines trumpet words like “crash” “bear market”, “extreme fear”, and “volatility“. Red is the predominant color on financial news service websites. Is it time to panic sell all your equities? Should you go all in on the US Stock market?
First: Don’t Panic
OK, take a deep breath. Don’t panic. 20% drops actually happen rather regularly. The current drop happened over a period of about six months. `Here’s an image showing the distribution of S & P 500 price changes for 6 month intervals.
The light red dashed line is at -10% or “correction” territory. The dark red dotted line represents -20% or the threshold for a “bear market.” Look how much of the distribution remains to the left of both of these lines. Neither event is uncommon. In the histogram, I also highlighted the 0% line in solid blue. Take heart doom and gloom fans: most of the distribution is to the right of that solid blue line. That means that most of the time, the market has a positive return.
Let’s look at the same data differently so we can more easily quantify how often to expect a -10% correction and a -20% bear to occur within a 6 month window. Corrections happen about 10% of the time. That 20% bear market line happens about 3% of the time. There’s a reason why people smarter than me have said that over time, “it always goes up .”
Second: The Market Isn’t That Cheap Yet
Believe it or not, we’re not at bargain basement prices yet either based on two widely accepted measures of aggregate market value.
1) the “Buffet indicator“, which looks at a country’s total stock market’s price relative to the economic output of that country. Economic output is usually measured as Gross Domestic Product. Here’s a detailed discussion if you want some real gory stuff. While the current market conditions have improved from late 2021/ early 2022, valuations are still relatively high.
2) the Cyclically Adjusted Price to Earnings ratio (CAPE) or Shiller PE is another measure of long term value. It too is still high by historical standards despite recent sell-off. As of this writing, the Shiller PE is above 30 against a long term average of about 17.
Of course, I don’t have a crystal ball that sees into the future. However, based on measurements like these that show some good predictive power with long term stock market returns, it might make sense to make a measured response.
How to Respond to a Market Downturn
With a 20% drop, your asset allocation is likely out of balance. you can think of the market on sale and consider this an opportunity to re-balance. Sell some bonds and buy some stocks to bring your asset allocation ratio back to your goal.
Continue investing regularly or dollar cost averaging. Stay the course and try to avoid any drastic action. You’re investing for the long haul. As we’ve seen above, dips happen regularly.
If you have low enough expenses, consider investing some extra funds while prices have reduced. I would be cautious of going all in at this time though.
Stay diversified. It’s tempting to think we’re able to pick individual winners. For most investors who aren’t spending their free time reading prospectuses our scouring the headlines for information about a company, buy the entire market (or at least a big chunk of it) and ride the tide.
Disclaimer: While we have a passion for providing entertaining, informational, and possibly useful articles about personal finance, we’re just random people on the internet with no formal credentials or expertise. Talk to a licensed professional advisor if you need advice.