Is a Market Correction Imminent?

The market has allowed itself a well-deserved "cool down" period during the month of August. In fact, heading into today, both the S&P 500 and the Dow Jones Industrial Average have seen four straight negative days and endured losses during nine of the last eleven days.

After the roaring bull market we've enjoyed since April 2009, it is natural for investors to question whether this is a turning point and the market is destined for a significant pullback. First and foremost, it is valuable to remind ourselves that even through the woes of August, the S&P 500 is only down 3.7% from its recently achieved all-time highs.

Second, it is useful to define some terms, as Josh Brown, one of my favorite Wall Street writers, recently did:

Percentage Drop:	Defined As:	Feels Like:
Less than 5%	Pause	“whatever”
5% to 10%	Dip	Refreshing
10%+	Correction	Nerve-wracking
20%+	Bear Market	Panic
50%+	Crash	Can’t Get Out of Bed

You may have heard the word correction in the financial media lately. With a market pause still under 5%, it's probably a bit early to start talking about a correction. Still, let's assume we are headed for an actual correction, or a loss of 10% to 20%. What should we expect? Here are some interesting numbers that Mr. Brown accumulated:

• Since the end of World War II (1945), there have been 27 corrections of 10% or more. Only 12 of these corrections evolved into bear markets (a loss of 20%+). The average decline during these 27 episodes has been 13.3% and they've taken an average of 71 trading days to play out.
• On average, the market has endured a correction every 20 months. Of course, the corrections aren't evenly spaced out -- 25% of the corrections occurred during the 1970's, and another 20% occurred during the secular bear market of 2000-2010. However, from 1982 through 2000, there was just four corrections of 10% or more. This is relevant as it illustrates that bull markets can run for a long time without a lot of drama.
• Since the stock market's bottom in March of 2009, there have been two corrections. In the spring of 2010 the S&P 500 lost 16% over 69 trading days. In the summer of 2011, the S&P 500 dropped a hair over 20% before snapping back. Technically, this qualified as a bear market, which would mean the current rally is only two years old as opposed to almost five years old if dated from March of 2009. 
• The market pulled back 9.9% during 60 days in the summer of 2012. While not quite a correction, this dip set up one of the greatest rallies of all time.
• There have been 58 bull market rallies (defined as market advances of 20% or more) in the post-war period, and they have run for an average of 221 trading days and resulted in an average gain of 32%. Comparatively, when measured by both length and magnitude, the current bull market is overdue for a correction and has been for awhile.

So what should you do assuming we are heading for a correction? First, it is critical to remind yourself that if you are following sound financial planning principals, you already have an investment portfolio that matches your risk tolerance and investment time horizon. Remember that just because the market lost 10% doesn't mean your portfolio lost 10%. In fact, if you scaled back the assertiveness of your portfolio as you transitioned into retirement and your portfolio is only 60% stocks, your portfolio is likely only down approximately 6%.

Second, in the instance of an investor with a portfolio that is 60% equities, recall that you selected such a portfolio because you deemed a 6% loss to be acceptable. In fact, if due diligence was completed when you selected an asset allocation, you were aware that the largest loss a 60% stock, 40% bond portfolio suffered during the last 44 years was -19.35% (2008), and you were aware that such a loss could (and likely would) happen again and you determined that was acceptable.

Thus, for investors who have done their planning, the best thing to do in the event of a market correction is grit your teeth and do very little. For those who haven't planned in advance, now would be an ideal time to do your homework and create a portfolio that matches your situation and behavior patterns. Once you've done your planning, all you need to do is remember what Josh Brown calls the ABCs of investing: Always Be Cool.