Trying to Predict the Unpredictable

Negative market volatility returned last week and continued Tuesday, running counter to the year's overall relative calm. Hard as it may be to stomach at times, volatility is normal during bull markets. It's also the price you occasionally must pay for stocks' long-term returns. Staying cool amid swinging markets is usually the right move, but for many folks, this is easier said than done. Volatility can cause investors to search for bigger issues behind the moves-or extrapolate recent downside forward, both big pitfalls. We see this in the press today, with headlines wondering if the long-awaited correction is coming. Or near. Or perhaps already here. And while all are possible-corrections occur without warning-in our view, predicting corrections isn't a viable strategy, and trying is counterproductive for long-term investors. Pundits' efforts to do so over the two-plus years since the last correction should serve as a stark reminder of that.

Definitions of corrections vary. Some thought a volatile week in January was a correction. Others skew the opposite direction, calling 40% drops "corrections"-a magnitude we'd call a big bear market. In our view, corrections (technically speaking) are short, sharp, sentiment-driven drops of -10% or more. They usually end as quickly as they begin, and they're a normal feature of bull markets. In contrast, bear markets are drops of 20% or more, caused by big, bad, surprising fundamental factors. They last longer than a few weeks and usually occur just before a recession. 2008's financial panic and 2000's dot-com implosion were bears. 2010's -17% move, ostensibly tied to Greek fears, was a correction. Not all negativity is the same.

The last global market correction was in 2012, when the MSCI World fell -12.5% from 04/02/12 - 06/04/12.^[i] Ever since, folks have hunted the next one. Here is a little timeline:

2012

"A Stock Rally This Summer? Don't Bet on It"
The Wall Street Journal, 06/11/12 (one week after 2012's correction ended)

"With global growth softening, near-term monetary stimulus unlikely, earnings growth having decelerated and European political risk having re-emerged, we think the current correction is likely to last until the third quarter."

"The Year of Betting Conservatively"
Project Syndicate, 11/29/2012

The upswing in global equity markets that started in July is now running out of steam, which comes as no surprise: with no significant improvement in growth prospects in either the advanced or major emerging economies, the rally always seemed to lack legs. If anything, the correction might have come sooner, given disappointing macroeconomic data in recent months.

2013

"Investors' Early 2013 Exuberance Due for Correction"
The Wall Street Journal, 01/14/2013

Two weeks into the new year, the pendulum already appears to have swung too far towards the positive. The investor rush to take on risk appears to have pushed equity, bond and the riskier currencies to levels unjustified by fundamentals. And the end result, most likely, will be a correction.

"S&P 500 Targets First 10% Correction in Two Years"
The Wall Street Journal, 06/24/2013

For chart watchers, the stock market may not yet be in official correction territory. But technicians say it is now a matter of when, and not if.^[ii]

"September Is Stocks' Cruelest Month"
MSN Money, 08/08/2013

My own prediction is that the market will stage a correction here. By definition, that's a drop of 10% or more. I think that's the likely dimension of a September drop on worries about the Fed and a Washington deadlock, based on the dimension of the drop in 2012 on the fiscal cliff fiasco and the length of time this rally has run without even a 10% drop. ... We haven't had one of these events in a long time, and it's reasonable to think we're due for one.

2014

"One Bear's Gloomy Forecast: Stocks Down 20% in 2014"
The Wall Street Journal, 01/02/2014

U.S. stocks can't go straight up forever. And if the end of QE1 and QE2 taught investors anything, the market could suffer a significant correction this year as the Federal Reserve starts dialing back its stimulus.

"Is This the Correction, or a Coming Crash"
MarketWatch, 03/27/2014

Has the correction finally started? There are enough things happening behaviorally within the market to consider this. The deflation pulse, which has been a big theme of mine over the past year, remains alive and well.

"Is a Stock Market Correction Overdue?"
MarketWatch, 06/09/2014

Trading volume and volatility are dragging along low levels as stocks reach new highs. That's made for a nervous complacency where a correction could really blindside investors, some stock pickers are warning.

We could continue. Our point isn't to highlight who's right and who's wrong-rather, the whole exercise of forecasting corrections is, in our view, misguided. We aren't aware of any forecaster with a track record of repeatedly getting corrections right. Yet the hunt continues. Why? As economist Daniel Kahneman theorized, humans feel the pain of loss over twice as much as the joy of gains. Those quick drops drive angst. Folks extrapolate recent trends forward and fear more is in store. And very often, they want to run for cover.

But consider the bigger picture. This bull market-which began March 9, 2009-has seen five global equity market corrections. From the start through August 5, 2014, global markets are up 177%-corrections included!^[iii] The likelihood you could improve on this by timing sentiment-driven market moves is tiny-you need to get out before the lion's share of negativity is over and get back in before stocks snap back. Usually, that's when most are warning the bottom is about to fall out.

For investors, being out of the market carries opportunity cost. Unless you happen to be the world's greatest market timer,^[iv] remaining disciplined and riding through a correction will benefit your portfolio's long-term prospects more than waiting for one to pass. Corrections don't sound an "all-clear" signal once they're over-once markets reverse their direction and start rising again, you don't want to be stuck on the sidelines wondering if the correction is over or not. After all, you could miss every correction-in fact every bit of negativity ever-by just investing in cash. Only problem is, that would likely greatly magnify the chances you miss your investment goals, too.

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[i] Source: FactSet. MSCI World Index net returns.

[ii] This is always true.

[iii] Source: FactSet, MSCI World Index net returns, 03/09/2009 - 08/05/2014.

[iv] If you are, you probably don't need to be reading this.