While there has been some rebound today, the sell-off in stock markets from Thursday to Monday’s trading sessions was sharp and accompanied by a significant increase in volatility. We discuss how this current pullback and market volatility compares historically, and what this may infer for forward stock market returns.

After an extended period of a “bad news is good news” market, with participants believing data on a slowing economy would give the Federal Reserve (Fed) clearance to cut interest rates, we appear to have abruptly moved to a “bad news is bad news” environment. Market concerns have coincided in the last few days with worries rising that the Fed’s higher-for-longer stance may be a policy error that will drive the U.S. economy into recession (a so-called hard landing) following the weak payroll employment report on Friday, August 2. Weakness has been further exacerbated by the continued unwinding of yen carry trades following last week’s Bank of Japan rate hike and a hawkish tone from Bank of Japan Chief Kazuo Ueda. On top of these primary issues, there are concerns over rising Middle East tension involving Israel and Iran, U.S. political uncertainty following President Biden’s withdrawal from the 2024 election, and negative seasonality (with August typically one of the weaker months in recent years). Sentiment had also become frothy, and valuations stretched. All in all, the perfect recipe for a meaningful pullback or correction, as we noted in ourMidyear Outlook 2024: Still Waiting for the Turn,stocks were overdue.

The wall of worry the market has built up has manifested itself in a drawdown in the S&P 500 of almost 8.5% from the highs, set on 16 July, to Monday’s close, and a drop of 6% over the Thursday to Monday’s trading sessions. Meanwhile, the tech-focused NASDAQ and small cap Russell 2000 equity indexes are both in correction territory after falling more than 10% from their respective highs. The VIX Volatility Index, a measure of implied volatility sometimes referred to as the “fear index”, jumped from around 16 on Wednesday, July 31,to close at over 38 yesterday (with an intraday spike to over 65).

While such sharp declines in equity prices are concerning, looking back at historic data on the S&P 500 index reminds us that dips, pullbacks and corrections of 10% or more are a normal and healthy part of any bull market. On average, stocks experience a pullback of over 5% over three times per year and a correction of 10% or more around once per year — even in positive years. Expressing this data another way, 94% of years since 1928 have experienced a pullback of at least 5%, and 64% of years have had at least one 10% correction. We believe that how common these occurrences are should provide comfort to equity investors, allowing them to be patient, stay invested, and most importantly, to not panic.

Dips, Pullbacks and Even Corrections are Normal

Source: LPL Research, Ned Davis Research 08/02/24
Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. The modern design of the S&P 500 Index was first launched in 1957. Performance before then incorporates the performance of its predecessor index, the S&P 90.

The S&P 500 fell 3% on Monday; but prior to this 2024, and 2023, had been an abnormally calm years with regards to large daily moves. Before the last week in 2024, there had been one other down day of more than 2%, in late July, and one up day of over 2% (in February). As depicted in the chart below, in recent history, higher frequencies of large daily returns tend to happen in years with recessions or bear markets, but even in bull markets, a handful of such days per year are not uncommon.

Stocks Haven’t Seen Many Large Daily Swings Since the 2022 Bear Market

Source: LPL Research, Ned Davis Research 08/02/24
Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.

Days such as Monday, when stocks are down 3% are fairly abnormal outside of recessions, occurring a few times or not at all in non-recessionary years. The average number of down days of 3% or more per year is 3.7 in all periods since 1928, which includes the Great Depression era, and falls to around 1.8 per year since the advent of the modern S&P 500 in 1957. However, this century has been fairly volatile relative to the 1950s to 1990s, with an average of 3.8 occurrences of down days exceeding 3% per year.

3% Daily Drawdowns are Uncommon, But Not Unheard Of, Outside of Recessions

Source: LPL Research, S&P Dow Jones Indexes, Bloomberg, Factset 08/05/24
Disclosures: All indexes are unmanaged and cannot be invested into directly, Past performance is no guarantee of future results. The modern design of the S&P 500 Index was first launched in 1957. Performance before then incorporates the performance of its predecessor index, the S&P 90.

Investors searching for some positive signals among the sell-off of the last few trading sessions might find them when looking at forward returns after either a greater than 3% daily drawdown or a greater than 6% three-day drawdown. There have been 354 such days since 1928 when the S&P 500 was down 3% or more, and the average (and median) three-month, six month and one year forward returns are all higher than long-term averages. When examining the returns after a three-day drawdown of 6% or more, as we just experienced, returns are even stronger, with the average return in the next year at over 15%.

Large Drawdowns Tend to Precede Above-Average Returns

Source: LPL Research, S&P Dow Jones Indexes, Bloomberg, Factset 08/05/24
Disclosures: All indexes are unmanaged and cannot be invested into directly. Past performance is no guarantee of future results. The modern design of the S&P 500 Index was first launched in 1957. Performance before then incorporates the performance of its predecessor index, the S&P 90.

The extreme levels the VIX reached Monday morning have historically been associated with market capitulation, but remember bottoming during corrections usually takes some time, with ups and downs even within this process. The closing VIX at 38.57 on Monday represented its highest close since 2020 and is in the top 97% of closing values this century (the VIX spent a considerable amount of time elevated above 40 during the Great Financial Crisis). Other measures of sentiment were also looking washed out, including CNN’s Fear and Greed Index. The composite of seven market indicators, which scored 16 out of 100, is indicating “Extreme Fear” and that capitulation, and therefore a bottom, could be near (or have been hit already).

Summary

Elevated volatility and stock market drawdowns can be unsettling, especially after periods of calm, but in many ways, they are the price of admission to the stock market's positive returns over most intermediate-to-long time periods. LPL’s Strategic and Tactical Asset Allocation Committee (STAAC) maintains its tactical neutral stance on equities, while actively monitoring signs the bottoming process is playing out. While we remain cautious, potential catalysts for a stock market turnaround include signals from the Fed that they may be more aggressive with rate cuts, or evidence such as the ISM services data that the economy is holding up okay rather than falling off a cliff. Markets may also refocus on corporate fundamentals, including the Magnificent Seven’s expected earnings growth near 30% and resilient overall estimates (even as some companies warn about consumer spending pressures) and corporate buybacks could pick up now that most companies have reported results for the second quarter. Many sentiment measures are also at pessimistic/fearful levels that have historically been contrarian indicators. Even after this morning's strong rebound in Asia, and more muted effort in the U.S., showing the market starting to consider these reasons not to panic, a specific note of caution relates retail investor flows; retail investors are often the last shoe to fall when it comes to capitulation, and retail “buy the dip” flows into equities have been extremely strong over the past few days.