Haircuts and Roulette Wheels: Are we “Due” for a Correction?
Like most people, I suppose, I get my hair cut every four weeks. If, either by consulting the calendar or the mirror, I am “due” for a haircut, I head off and get one. The passage of time or the growth of my hair since my last visit, is a very reliable predictor of the timing of my next one.
If, on the other hand, I spend an evening sitting at a roulette table, hypnotized by the spinning wheel, and stake a bet each time on lucky number 7, the length of time since it was last called out has no bearing on when it will be called again. I may feel that I am “due”. But the reality is that each spin is independent, with an exactly 1-in-38 shot of providing me with a win. Of course, given a 1-in-38 shot, 7 will eventually come up. But the number of spins since the last 7 has no bearing on that probability.
Since the short, sharp bear of February and March 2020, the stock market has moved very steadily higher, with the S&P500 logging a more than 100% increase by earlier this month. This has led many to argue that we are “due” for a correction. But does the increasing length or strength of a bull market actually make the next correction more imminent? In other words, is the stock market more like haircuts or roulette wheels?
This is actually a relatively easy question to investigate. First, to be precise, a stock market correction is defined as a decline of at least 10% from a recent peak. That peak does not have to be an all-time high. However, by convention, we only count a new correction as occurring if the market has rebounded at least 10% from the trough of the last one.
Using these rules, there have been 36 corrections in the S&P500 since 1950 and the average length of time between the start of corrections has been 748 days.
If corrections were as regular as haircuts then there would be no variation in this number. The expected length of time between corrections would be exactly 748 days, with a standard deviation around that expectation of 0 days. With 579 days elapsed since the last correction started, we could note on our calendars that we have 169 days to go until the next one.
If, on the other hand, the length of time since the last correction had no bearing at all on the timing of the next one, then the length of time until the next correction would technically follow what is known as a geometric distribution, with an expected wait of 748 days until the next correction and a standard deviation around that expectation that also, conveniently, equaled 748 days.
So which of these most closely resembles actual history?
Well, since 1950, while the average length of time between the start of corrections has been 748 days, the longest has been 2,640 days, between 1990 and 1997, and the shortest has been 131 days, in the winter of 1980.
Importantly, the standard deviation of these times has been 540 days. This is 72% of the standard deviation we would expect if the probability of correction was independent of the timing of the last one. So mostly roulette wheels, but partially haircuts.
Alternatively, we could argue that we were “due” for a correction because of how far the market had run. On average, since 1950, the percentage gain from the bottom of a correction has been 49.8%, ranging from a spectacular 233.9%, in the run from 1990 to 1997, to a wimpy 12.9% in 2015. Importantly, the standard deviation around this gain has been 42.5%.
Again, if the stock market behaved like haircuts, then once the market had advanced 49.8% from its low, it would have a correction.
49.8%, that is, with a standard deviation of zero.
If the stock market behaved like a roulette wheel, then the observed standard deviation on gains from lows would be 49.8%. The fact that it has actually been 42.5%, or 86% of the predicted “roulette wheel” result, suggests that the timing of corrections is even more independent of how far it has run thus far. Even less like a haircut and more like a roulette wheel.
So, in late September of 2021, we really can’t say we are “due” for a stock market correction because of the length or strength of the stock market run of the last 18 months. However, unlike roulette, there are very important fundamental forces that determine the behavior of markets over time and the week ahead will provide significant information on these forces.
- The pandemic still dominates the investment environment with an average of 2,000 people dying every day from the coronavirus. Thankfully, the number of new cases and hospitalizations appear to have peaked but there is real uncertainty about how fast they will come down from here.
- On fiscal policy, Democrats will be scrambling this week to try to assemble votes to pass both the reconciliation bill and the infrastructure bill, as well as an increase in the debt ceiling and a continuing resolution to keep the government open past September 30th. In theory, there is a path to do all of this – but it is a narrow path, strewn with land mines, and Wall Street will have every reason to worry about a misstep.
- On the economic front, we expect to get generally downbeat economic data on housing this week although numbers on unemployment claims will likely be examined most closely to see if the labor market is continuing to tighten.
- Finally, the Federal Reserve holds its sixth FOMC meeting of the year this week. Given the uncertainty about the pandemic, fiscal policy and economic data, it seems unlikely that they will make any significant announcement. However, their statement, their economic forecasts and Chairman Powell’s press conference will all be scrutinized for hints about when the Fed will begin to taper its bond purchases and the likely pace of that reduction. For the record, we still expect a November FOMC announcement of tapering to begin in December, with bond purchases falling by $15 billion per month.
For investors, it is a complicated picture and one which requires balanced judgment. We cannot depend on any simple rules to determine the timing of the next correction. In addition, there is unusually high uncertainty about fundamentals due to the unpredictable nature of the pandemic, high-stakes political negotiations in Washington and the unusual forces both powering and impeding an economic recovery, as we adapt to, or move on from, the pandemic.
What we do know, is that in the long run, valuations matter. This still suggests a relatively short-duration approach to fixed income, an overweight to value stocks within the United States and overseas equities relative to their U.S. counterparts and broad diversification to include alternatives in portfolios.