Are We Due for a Pullback?

In the summer of 2015, the stock market pulled back. The decline that accompanies that pullback would end in February 2016 after a 14% decline in the S&P 500. Since that time,the index has moved nearly straight up without a pullback. In this article, we look at whether or not that is unusual.

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  • Or, more specifically, we look at how unusual this winning streak has been and what the implications for the future price action are.

    To begin with, we need to define some terms:

    We are defining a pullback as a decline of at least 5% from a prior high but no more than 9.99%. A decline of at least 10% but no more than 19.99% is considered to be a correction. A bear market is defined as a decline of at least 20%.

    To measure the declines, we are using the S&P 500 index, a broad benchmark of the stock market. The S&P 500 is highly correlated with other major market indexes and the results using other indexes would be similar.

    Using these definitions, we find that there has been an average of one pull back a year since 1945. On average, we experience a correction every 2.8 years and a bear market every 3.8 years.

    That means the recent period of almost 22 months without a pullback is unusual.

    pullback

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  • Source: S&P Dow Jones Indices

    Before looking at the recent market action, let’s consider the important question of how long it takes to recover from a market decline. Here; the news is fairly good.

    Recoveries have come fairly quickly after a pull back.

    The 56 pull backs since December 31, 1945 pushed the S&P 500 down an average of 7%. On average, the decline occurred over a one month period. Then, on average, the S&P 500 required just two months to recover 100% of the amount lost in the decline.

    On average, rallies erased declines fairly quickly after steeper declines.

    It takes an average of about four months for the S&P 500 to recover from a correction. Although it can vary, the average recovery period from a bear market is just 14 months.

    Of course, there have been worse than average markets. The S&P 500 has suffered three deep bear markets since 1945, losing more than 40% of its value. Two of those declines are fairly recent and include the 2000 bear market and 2008 financial crisis. The average recovery time after these bears has been 58 months.

    The Current Streak Is Near a Record

    With a sense of history, and some perspective on how damaging losses can be, we can consider how this current market winning streak fits into history. Here, the story should ease the worries of some investors. Measured by calendar days, we are now enjoying the fourth longest streak without a 5% decline.

    Source: LPL Research

    At this point, it is important to consider what happened next.

    The longest streak ended in July 1996. The pullback that ended that winning streak was just about 6%. That pullback, in hindsight, proved to be a buying opportunity.

    After the longest period of time without a 5% pullback, the stock market remained strong for nearly two years. There was another pullback along the way but the S&P 500 gained more than 85% in the next two years.

    Then, there was a crisis. In 1998, the worst financial crisis up to that time resulted in a brief bear market. A hedge fund run by Nobel Prize winning economists blew up in the summer of 2008 and sparked a global financial crisis. Derivative and credit markets required a bailout engineered by the Federal Reserve.

    But, that crisis came nearly two years after the stock market delivered its longest streak of gains without a 5% pullback.

    After the second longest streak, there was also a fairly shallow pull back followed by a strong recovery and then a bear market.

     

    The third longest streak without a 5% decline ended in early 1994. Here, we see a different pattern than we saw in the previous two charts.

    Winning Streak

    In this case, the S&P 500 index traded sideways for about nine months. It then embarked on what would be the longest period of time without a 5% decline that began in December 1994 and is shown above in the first price chart.

    Strength Often Leads to Strength

    Traders often look to the world of sports for analogies to what they see in the financial markets. When considering streaks, one of the most memorable in the sports world is Joe DiMaggio’s record of recording at least one base hit in 56 consecutive games.

    Less remembers is that DiMaggio started a second hitting streak, one that would last for 16 games, the game after the record setting streak ended. For baseball fans, the astounding fact is that he attained a hit in 72 of 73 consecutive games.

    The end of the first streak was simply a pause in an incredible period of hitting strength for DiMaggio. Sports fans may also think of this as the shooter with a hot hand in basketball or the runner at the top of his game in other sports.

    In the Stock Market trading, we also see strength lead to continued strength. This is the basis of relative strength. It is also the basis of an investment opportunities that has been proven to beat the stock market in the long run.

    Relative strength is also called momentum.

    The current stock market is exhibiting a great deal of momentum. When we visualize momentum, we often picture high momentum giving way to a slowdown in momentum before a reversal in the trend.

    In the current market environment, that pattern is already underway. We are enjoying a stock market with high momentum. Momentum will slow, and that should take the form of a market pullback followed by another burst of momentum. Then, after some time, a trend reversal should be expected.

    Looking Ahead, Based on Previous Long Streaks

    History tells us three things about the current market environment.

    First is that we are most likely within just a few months of the 5% pullback. The longest such streak lasted 569 calendar days. That is less than two months longer than the length of the current streak. It would not surprising to see a pullback develop soon.

    Second, the pullback which develops is likely to be shallow. We have just a few examples but the three longer streaks all gave way to pullbacks rather than corrections or bear markets. That indicates we should expect a decline of 5% to 10% rather than a bear market.

    Third, after the pullback is completed, we should expect a strong rally with at least a double digit gain. This indicates we should see more new highs in the stock market. After that, there is an increasingly large probability of a bear market.

    Based on history, investors should remain bullish.

    The stock market is likely to deliver significant gains over the next six months. It is possible to see very large gains, assuming the same pattern we saw in the 1990s plays out.

    When the next pullback comes, it should be considered a buying opportunity. Eventually, we will see a bear market but that is most likely not until at least the second half of 2018 and possibly even in 2019.

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