Learn to Love the Pullbacks

After four long years without a 10% pullback, the S&P 500 finally experienced a correction in late August. Hooray! If you are puzzled by my excitement, allow me to try and persuade you to embrace the pain. While it’s contrary to human nature to feel happy about a decrease in wealth (however temporary), doing just that can help one become a better investor, or at the very least, avoid making costly mistakes.

Everyone says that they want to buy low and sell high. Yet when Morningstar studied the performance that actual investors earned in various mutual funds by looking at asset flows (the timing of purchases and sales) versus the average return for a dollar bought and held over a 10-year period, it found that mutual fund investors cost themselves on average 2.5% per year through timing decisions. In other words, people tend to buy high and sell low.

While that difference may not seem like much in any one year, over a 30-year period an investor giving up 2.5% a year would end up with less than half as much wealth. Such wildly different outcomes for people invested in the exact same funds is remarkable and all thanks to the human emotions of fear and greed.

About those emotions, Warren Buffett famously said to be “fearful when others are greedy and greedy when others are fearful.” He made his fortune by focusing on his long-term horizon and buying at low prices in times of uncertainty. It’s important to remember that there are two sides to every trade: someone was selling low and giving up future gains to Buffett. Don’t be that seller.

In fact, pullbacks are often great times to be a buyer. Most investors have portfolios that are a mix of stocks, bonds and cash. Periods of unrest in the stock market are often accompanied by a decrease in interest rates (and therefore an increase in bond prices), making it a great time to rebalance portfolios by trimming bonds at higher prices and using the proceeds to buy stocks at lower prices.

This strategy worked well in 2008 and 2009, for example, when U.S. Treasury bond prices spiked as investors sought safe assets amid the financial crisis and stock market crash. A portfolio that was rebalanced to buy stocks as they declined and sell appreciated bonds didn’t have to time the bottom exactly right to significantly outperform a portfolio that simply held tight, or worse yet, sold stocks out of fear. The transfer of value to patient, long-term investors from “Nervous Nellies” is thanks to market pullbacks like we saw in 2009 and (to a lesser degree) in August.

In addition to providing opportunities for reba-lancing, corrections are healthy for markets. They prevent bubbles from growing too large and force market participants to examine fundamentals. Markets can’t move straight up forever, a lesson the Chinese government is learning right now, despite their efforts to the contrary. The correction in August ended a 1,417-day run that was the second longest period of time between 10% pullbacks in the S&P 500 since World War II. On average, the S&P 500 experiences such a pullback slightly more than once per year, so the market was statistically overdue for a move down.

So now that we’ve gotten the long-expected correction, where do we go from here? While predicting short-term returns is notoriously difficult, a look back at history can be instructive. For example, since 1940 there have been 10 instances of 10% or greater declines over four trading days like we saw in August (see chart on page 3). Returns after such quick, sharp moves down have been quite strong. In fact, nine out of the 10 instances saw positive returns in the S&P 500 one year following the correction, with an average gain of more than 20%.

The fourth quarter has also been historically quite good for stocks. Over the past 25 years, for example, the market has gained more on a total-return basis in the fourth quarter than the previous three quarters combined.

Of course, there is no guarantee that history will repeat itself this time around. But also in the positive column, the U.S. economy appears to be gaining strength. Unemployment in the U.S. is now 5.1%, a level not seen since before the Great Recession. Wage growth, while still historically low, is trending higher. The housing market continues to improve, and American corporations have strengthened their balance sheets and are enjoying profit margins near all-time highs.

Like always, there are some potential storm clouds on the horizon. The Chinese economy is weakening and has weighed on other emerging-market economies and stock markets. European countries are suffering from high unemployment and on the receiving end of mass exodus from troubled areas in the Middle East. Commodity prices continue to fall, which is good for consumers but painful for the energy and materials sectors of the economy and those who work in those industries.

Last but not least, the Federal Reserve’s decision in September to leave short-term interest rates at 0% muddies the economic outlook further. Given the U.S. economy’s continued strength and the low unemployment rate, about half of economists surveyed before the decision expected the Fed to increase the benchmark Fed Funds rate above the emergency level of zero it has maintained since late 2008.

The Fed has a dual mandate of full employment and stable prices. While it has clearly succeeded on improving the employment front, the Fed pointed to inflation that has been persistently below its long-term target rate of 2% in its statement explaining why it decided to leave rates unchanged.

There is no consensus view on what the Fed’s decision means for the economy and given the unprecedented length of time and degree of market intervention (Quantitative Easing I, II and III), history is no guide. Some worry that the Fed’s refusal to raise rates indicates that the decision makers on the Federal Open Market Committee (FOMC) see signs of weakness in the economy that other market participants have missed. I find this argument rather unconvincing as the Federal Reserve does not have a good track record of predicting recessions. Even in October 2008, for example, the Fed was still predicting the U.S. economy would avoid a recession even with obvious turmoil in the housing market.

Despite having only two months left in the year, the Fed missed the forecast terribly as the U.S. plunged into recession, recording its worst GDP number since 1946.

Perhaps a more reasonable concern is the possibility that keeping the cost of money so low for so long can create unintended consequences such as asset bubbles. As Benjamin Graham noted, stocks and bonds may go up or down in the short run based on fads, emotions and “animal spirits.” But in the long run, the market weighs fundamentals and aligns asset prices with underlying values.

Certainly both stocks and bonds have appreciated to a greater degree than they would have without such loose monetary policy. But what happens when interest rates normalize and the market begins weighing fundamental values in an environment without Fed intervention is still an open question.

One thing is for sure though: at some point there will be another recession or even just another sharp market drop, and it will take many people by surprise (maybe even the Federal Reserve!). Some investors will panic and decide to sell at any price. Savvy buyers will keep their emotions in check and use the opportunity to make long-term purchases at low prices.

So the next time volatility strikes, remember to embrace the pain. Or at least take some aspirin and try to ignore it. Your future self will thank you.