The U.S. stock market has been on such a parabolic march higher that Wall Street investors may have forgotten what a typical, sharp downturn feels like.
Indeed, much has been made about the lack of volatility. The CBOE Volatility Index
otherwise known as the “fear gauge,” had been flirting with its lowest close on record, implying that market expectations for a sharp, sudden fall are near rock bottom, as the Dow Jones Industrial Average
S&P 500 index
and the Nasdaq Composite Index
scale new heights—Friday’s downturn notwithstanding.
The recent level of complacency permeating the market has pundits talking about the lack of 5% falls in the market—an occurrence that isn’t unusual in a normal market environment. However, a 5% tumble, while normal, isn’t that common either. It has occurred at least 75 times over the course of the blue-chip index’s, according to WSJ Market Data Group, using data going back to 1901. The Dow, however, hasn’t experienced a 5% decline since 2011, and before that a 5% drop hadn’t happened since 2008, when there were 9 such drops (see chart below):
At this point, with the Dow just 200 points shy of 22,000 a 5% selloff would equate to a 1,100-point, one-day slide in the gauge. Is the market ready for that sort of sudden jolt lower, given the optics of a quadruple-digit downturn and how it might rattle investment psyche?
Art Hogan, chief market strategist at Wunderlich Securities, doesn’t think so.
“I would say no because we’re out of practice. You’re usual standard garden-variety volatility just hasn’t been around and we haven’t seen it for 12 months,” Hogan told MarketWatch.
“Quiet markets have been the norm and not the exception and I think a major pullback is going to feel a whole lot larger for lack of experience and the numbers are larger,” he said.
“Quiet markets have been the norm and not the exception and I think a major pullback is going to feel a whole lot larger for lack of experience and the numbers are larger.”
Even a 2.5% drop in the Dow, adding up a 550-point drop, could be unsettling, market participants said. Those sorts of tumbles are far more frequent, with 564 such moves occurring in the Dow since 1901. The most recent slump of at least 2.5% was on June 24, 2016, when the Dow tumbled about 610 points, or 3.4%, a day after U.K. citizens voted to end the country’s membership in the European Union. There were 3 falls for the Dow of at least 2.5% in 2015.
Hogan said it is even hard to imagine what the landscape of the market would like in the face of a crash of the same magnitude of 1987 crash when the Dow lost 22.6% of its value, or 508 points, in a single session.
“That’s why it is hard for investors to think about it intuitively. We have no muscle memory for it. It’s hard to harken back to 30 years ago. We have been lulled to sleep,” he said.
As for the S&P 500, going back to 1950, 61 of the past 67 years have had a 5% downdraft at least once, or 91% of all years, according to Ryan Detrick, senior market strategist, at LPL Financial.
“The inevitable 5% drop will be a shock to nearly everyone,” Detrick said. “We’ve been historically spoiled so far this year, but as the economic cycle ages, we fully expect more volatility the remainder of this year and the likely 5% correction to take place as well,” he said.
Market bears have offered no dearth of warnings that a slide is imminent, including citing rich valuations of the biggest names in technology, including Facebook Inc.
Google-parent Alphabet Inc.
and Amazon.com Inc.
which considers itself online retailer rather than a tech behemoth.
Billionaire investor Howard Marks, co-chairman of Oaktree Capital Management, said “this is time for caution,” pointing to a number of bad-market omens. Those include trailing 12-month price-to-earnings ratios, a measure of valuation, for S&P 500 stocks running at 25 times. He said another valuation metric, the Shiller Cyclically Adjusted PE Ratio, known as the Shiller CAPE, is at its highest level since only two other times in the market 1929 and 2000.
On CNBC on Thursday, Robert Shiller described the low level of volatility in the market as concerning, saying he “lies awake worrying” about how this period of quietude will last before things unravel. Though he admits that it could run longer than academics, market pundits and market bears might expect.
So far, the market has demonstrated a preternatural resilience, shaking off political worries associated with an expanding investigation into Russia’s ties to members of President Donald Trump’s administration, infighting within that same administration, the unwind of easy-money policies around the world as the Federal Reserve attempts to navigate its own efforts to normalize interest-rate policy amid sluggish signs of wage growth, prices and inflation—key measures of economic health.
When, not if, things go pear-shaped, Detrick recommends that investors put the move into perspective:
“The important thing to remember is the Fed is still accommodative, earnings continue to improve globally, and inflation is contained — meaning any pullback could be a nice opportunity to add equity exposure. Although a 5% correction might feel like 1987 to some of us about now, pullbacks and volatility are perfectly normal parts of bull markets and are needed to flush out the weak hands.”