Making Sense of Market Corrections

Jeff DeMaso: Hello, this is Jeff DeMaso, director of research at Adviser Investments with another “Adviser You Can Talk To” podcast. Today I have as my guest Brian Mackey, who’s a senior research analyst at Adviser Investments. Brian has earned his Chartered Financial Analyst designation and carries a heavy load on the investment team. He’s involved in mutual fund research, individual stocks, and quantitative analysis. It’s no surprise he’s a go-to resource for colleagues and clients. So Brian, let’s get right down to it. What would you make of this market volatility?

Brian Mackey: First of all, thanks for the introduction. So I think the market volatility, this is a pretty standard correction in the markets right now. We’ve got some pretty cool research about how often we see drawdowns in the market, and we get drawdowns about of a 10% correction about every other year. Like clockwork it’s been almost exactly two years since the last 10% correction. So this is a pretty standard correction in the market.

Jeff DeMaso: So corrections happen, but it seems like in the market, at least in the media, they’re saying that interest rates and higher interest rates are why stocks have fallen. So is that the new paradigm, that higher interest rates equals lower stock prices?

Brian Mackey: That is definitely the story out there right now, and the reality is that if people fear that that’s the case, and that drives them to sell, then it can absolutely become true. It’s sort of a self-fulfilling prophecy. If you look at the longer-term data, our opinion is that, even if inflation does tick higher and interest rates go higher, it’s not necessarily a bad thing for the stock market. JPMorgan’s done some great research on this topic where they’ve looked at how changes in interest rates can affect the stock market. The basic conclusion that they come to is that when rates are low, below 5%, and the 10-year is at about 2.9% today. So anytime that it’s at rates where they are right now and rates go higher, it’s a sign that the economy is improving, and that tends to be a good sign for the stock market. It’s not until rates get above 5% and keep going higher that’s when either the economy is doing really, really well and the stock market’s kind of priced to perfection, or inflation is really kicking up well above 2% that we need to start worrying. We’re far from worried right now.

Jeff DeMaso: So kind of the idea that higher rates aren’t necessarily high rates just because we’re coming off such a low base?

Brian Mackey: Exactly, yeah.

Jeff DeMaso: Okay, all right. So you mentioned higher rates being a self-fulfilling prophecy. If higher rates are seen as being a negative for the market, what might be a catalyst for the market going higher?

Brian Mackey: We always talk about earnings and interest rates. Interest rates, when rates go higher, on the surface it’s a negative because bond yields become more attractive. Why would I own stocks when bonds are paying me large coupons? But earnings is the other side; we haven’t talked about that yet. Earnings are growing right now at about 15% year-over-year, and there’s no real sign that they’re going to start shrinking any time soon. Right now at least it seems the strength of earnings growth is going to overpower the effective higher interest rates, and that’s where we see things going.

Jeff DeMaso: Also in the media you mentioned earnings growing 15%, that’s great. But the economy is growing maybe 2 or 3%. How do we kind of square that, economic growth versus earnings growth versus market returns? Is it all like one plus one equals one or like the exact same?

Brian Mackey: Over the long, long term, you should see earnings grow with the economy. So the fact that earnings are growing 15% and the economy is growing 3% real and maybe 5% with inflation, that’s not sustainable. So we’ll probably see earnings growth come down to a more reasonable level. It tends to fluctuate quite a bit, and earnings growing 5% is still pretty attractive when you go out and buy bonds and you’re kind of locked in and there’s no growth of that income, whereas dividends can at least grow 5% a year. To me the fact that earnings can grow and continue to keep going higher tells me that stocks are still pretty attractive.

Jeff DeMaso: We’ve been talking about why the market moves and the media has this obsession with always giving a negative narrative for why the market moved even if it’s trying to explain a 0.1% move in the market or whatever. Why do we have this need to define why with the market?

Brian Mackey: My favorite is when the market starts down in the morning and the headline is, the market is down because of X, Y and Z. Then something happens or nothing happens at all, and the market just turns around, and then all of a sudden the narrative has to change. The market was up because of A, B and C. So there’s always some type of narrative out there, and I think it kind of comes back to the biology of human beings. If you think back to the hunter-gatherer years when you ate a berry and it got you sick, that was a pattern that you noticed. So the next time you saw that berry you said, I’m probably going to avoid it this time. You see a scary animal in the distance, and you realize that last year that same animal ate your cousin. You’re going to start running a lot faster than before.

Seeking patterns is, I think, a part of who we are as human beings. The problem with that is that sometimes we see patterns that don’t really exist. We try to make a story out of something that isn’t really there. My favorite scientific study that I’ve come across on this topic is, rewarding mice versus humans, where they did this study where 2/3 of the time if a mouse went to the left a mouse could go either left or right. And 2/3 of the time the left option gave them sugar water, and 1/3 of the time the right option gave them sugar water. So the mouse quickly figured out, well if I go left all the time I’m more likely to get sugar. And sugar is sort of the reward. If they did that trial nine times, six times they would get sugar water. But humans, we’re a little bit different where we’ll see this pattern of 2/3 vs. 1/3, and we’ll try to guess what the next one will be even if it’s random. Humans do the same thing, and say we go to the left two times, and we were right, the next time we’re going to say, oh it’s got to be, we’ve got to go right to guess the next pattern.

So humans in that same experiment will get it right five times, whereas mice will get it right six times. That’s very similar to guessing if the market’s going to go up or down. It’s really kind of a random fluctuation, and it’s tough to guess. Really what I’m trying to say is that mice are better investors than humans. (laughing)

Jeff DeMaso: Well you say that it’s kind of a random guess, and I think on a day-to-day basis it probably is maybe 51, 52% of the days the market has been up.

Brian Mackey: Sure.

Jeff DeMaso: But over the long term if you look at one year, that percentage probably goes up to 60, 65%.

Brian Mackey: Yup.

Jeff DeMaso: You know, over a 10-year stretch the market has historically been up 80% of the time. So I agree that there’s some element of guessing, but if you extend your time horizon, you do kind of want to be like that mice and always go to the left. You want to expect the market to go higher over time.

Brian Mackey: Yeah, I completely agree. I was asked a question recently on a day when the market was down 4% last week. The question was, should investors be scared? My answer was, well it kind of depends. If you have a time horizon of one hour, than yeah, you probably should be a little scared because anything could happen in an hour, especially when the market’s real volatile it tends to the next day be pretty volatile. But if your time horizon is a 10-year period or longer, then you should be pretty excited about any kind of downturn you get knowing that the long-term results, as you said, tend to pretty positive for stock investors.

Jeff DeMaso: So it’s kind of know yourself. Are you a trader, are you an investor? They’re not exactly the same.

Brian Mackey: Exactly, play to your strengths, exactly.

Jeff DeMaso: So we seek patterns as humans and we’ve got also the caveman brain of trying to avoid danger and recognizing patterns for danger. Stepping back to kind of where we started maybe to wrap up is how should investors think about the recent decline, recent correction, that we’ve experienced?

Brian Mackey: I always kind of come back to the historical data. I think that’s a good way to set the expectations really. So we had a 10% correction. 10% corrections happen every other year. The real question is how often does that 10% correction then become a deeper correction and something, a real bear market that we should be worried about? The data there says that we’ll get a 20% decline about every nine or 10 years, and we’ll get a 33% decline or greater every 18 years or so. So in a 20-year period you’re going to have probably about 10 corrections of 10%, but only one of them will lead to a 33% decline, and only two of them will lead to a 20% decline. So the other ones, the vast majority of them, we tend to go right back up. I guess my answer is I don’t know what will happen in the future, but the numbers tell me that I am probably going to paid to be optimistic and expect stock markets to bounce. And they have kind of bounced back the last couple days. The numbers seem to be playing the way they should be.

Jeff DeMaso: That is interim and the short-term corrections are normal.

Brian Mackey: Yep.

Jeff DeMaso: Some corrections will lead to bear market but not all corrections do. Even most don’t. So keep your eye on the long-term horizon, your long-term plan, which should include expectations for some volatility.

Brian Mackey: Absolutely, absolutely.

Jeff DeMaso: All right, great. This is Jeff DeMaso, and I want to thank you for listening to another of our “Adviser You Can Talk To” podcasts. I’ve been speaking with Brian Mackey. If you enjoyed this conversation, please subscribe to our podcast, or check us out at adviseryoucantalktopodcast.com. Your feedback is always welcome, and if you have any questions or topics you’d like us to explore, please email us at info@adviserinvestments.com. Thank you for listening.