Learning from the last bull market correction

CIO Global Blog

08 Feb 2019

This time last year, equity valuations were beginning to move to the higher side of fair value, and credit spreads were near their lowest level since the financial crisis. It felt like there was little risk priced in—no wall of worry to climb. On top of this, investors had become acclimated to an environment of extreme calm. Going into late January, stock markets had enjoyed 15 consecutive monthly gains, 19 months without a 5% drop in the S&P 500, and a calendar year of high yield bonds exhibiting less volatility than government bonds.

And then markets began to dwell on concerns that the end of the "Goldilocks" environment (solid growth, contained inflation, and gradual rate hikes) would give way to an "overheating" scenario. Markets started to build a fresh wall of worry, watching wage growth and inflation data to see if the Fed might need to accelerate its interest rate normalization. The US fiscal stimulus—coming at an unusually late stage of the economic expansion amid an already tight labor force and few signs of an output gap to close—added additional uncertainty over the path of inflation.

Thus, the long period of calm ended not with a whimper, but a bang:

  • The VIX index of implied volatility saw its largest ever 1-day spike in history—up 116%, nearly twice the previous record—enough to permanently shutter several short-volatility strategies.
  • The S&P 500 fell 10.2% in just nine trading sessions, seeing two greater- than-3% drops in a single week.
  • International stocks fared a bit better (MSCI EAFE –7.4%, MSCI Emerging Markets –8.6%), but the pain was widespread.

This sharp reversal left many investors feeling whiplash. In addition, the Bloomberg Barclays US Aggregate Bond Index had also fallen 1%, leaving few places to hide and prompting concerns that a "overheating" scenario could end up hitting everything in diversified portfolios. Some investors— worried that stocks and bonds might see a rare simultaneous sell-off—started to reduce risk, or look for alternative risk management strategies, including cryptocurrencies, which had rallied nearly 3,000% in the prior 12 months.

Fast forward about 525,600 minutes...

Overheating concerns have abated and the outlook once again looks closer to "Goldilocks": economic growth expectations have moderated, but a recession remains unlikely; inflation is stabilizing just below the Fed's target, and there's little doubt the bank can be patient with future hikes; and stocks are back at valuations that are fair, if not outright cheap.

Recent labor data suggests that there might still be some slack, with the participation rate rising once again. And, although wage growth continues, it is increasingly regarded as a boon for the consumer (and thus the US economy, of which 70% is consumer spending) rather than as an inflationary risk.

As you can see from the table below, last year's 10.2% drop in the S&P 500 ended up as a row on the list of "bull market corrections," rather than becoming a bear market. In fact, little did we anticipate at the time, the S&P 500 only stayed in "correction territory" (more than 10% below its previous record high) for one day, and the index notched another all-time high six months after the trough (seven and a half months if you exclude dividends).

As for the investors that chose to reduce risk, they missed some of the snapback gains, but also probably did okay. The bond market has gained 3.1% over the last year, and cash (US 3-month Treasury bills) performed decently at 2.0%. Meanwhile, the cryptocurrency bubble burst, costing speculators 60% to 80% of their capital—a reminder that if something looks too good to be true, it probably is.

What's next?

At its trough on Christmas Eve, the S&P 500 had fallen 19.8% from its 20 September 2018 record high. Stocks have recovered much of their losses since then, and the bond market is at another all-time high, up about 4.2% from its recent low last May, so many well-balanced diversified investors are quite near their previous high-water marks.

But until stocks notch another record level, this recent sell-off will remain an honorary member of the "bull market correction" club. We believe it will receive permanent status in the coming months, rather than morph into a dreaded bear market.
But before you breathe a sigh of relief and move on, please take a few minutes to read our recent report, Bear market guidebook (PDF, 2 MB). There's no substitute for experience, and bull market corrections offer rare opportunities to ask yourself key questions about whether your portfolio and your financial plan are resilient against the unknown. For example:

  • At its trough in December, the S&P 500 had fallen nearly 20% that month. How did that feel? Were you tempted to raise cash, or take advantage of opportunities?
  • If the market had fallen another 15%—the post-World War II bear market average—how would you have felt? What is your plan to adjust your spending or investment strategy in the event of such a drop?
  • The S&P 500 has been "underwater" (below its record high) for nearly five months. If markets stayed underwater until December 2021 (average) or November 2024 (the length of the Tech Bubble recovery), how would this affect your ability to meet short-term spending needs without selling stocks at bear market levels?

Not only do we not expect these negative hypotheticals to come to pass, we currently recommend a risk-on tactical position with an overweight to global stocks, which continue to look attractively priced. And we expect the current economic expansion and equity bull market to continue for some time—perhaps several years.

But investors should not wait until the next downturn is imminent before taking commonsense steps to plan for one. Our bear market guidebook provides a series of strategies that can reduce bear market pain and damage—while prioritizing those that limit the opportunity cost if, as we expect, this sell-off earns a permanent place in the table below.

Historical "bull market corrections"

Source: UBS, Bloomberg, as of 8 February 2019

Author: Justin Waring, Investment Strategist Americas, UBS Financial Services Inc. (UBS FS)
Michael Crook, Head Americas Investment Strategy, UBS Financial Services Inc. (UBS FS)