Stock Market Correction Is Deepest Since August, But Drawdown Is Still “Normal”
By James Picerno | The Milwaukee Company | jpicerno@themilwaukeecompany.com
The latest market correction leaves the S&P 500 Index 8.6% below its previous peak (as of Mar. 10 close).
The historical record suggests that the current drawdown requires as long as 2-3 months to potentially recover the previous high, assuming that the current level marks the S&P 500’s trough.
Drawdowns of -5% to -10% are modestly common through time, but sometimes mark a transition that leads to bear markets and deeper peak-to-trough declines.
The latest sell-off in the US stock market isn’t unusual – S&P 500 Index corrections of -5% to -10% from previous peaks are relatively common. What’s different and unusual this time is the trigger: A trade war initiated by the President of the United States.
The question is whether the current incarnation of trade-war risk that’s weighing on market sentiment persists and leads to a deeper drawdown? That’s challenging to forecast, to say the least, primarily because the market’s path ahead is heavily dependent on President Trump’s future decisions on trade policy. Given his mercurial nature, it’s fair to say that deciding what’s likely on this front is highly uncertain.
Meanwhile, the history of market drawdowns can be used to manage expectations about an eventual market recovery. In the next chart below, the relationship between S&P 500 drawdowns and subsequent recoveries of previous peaks is shown. As expected, deeper drawdowns equate with longer recoveries. Modeling the relationship suggests that the current -8.6% drawdown will likely take 2-3 months for the market to recover, based on the best fit via a linear regression model. If the correction continues and the drawdown slips to -15%, the implied recovery time may be roughly 150 trading days, or about eight months, according to the best-fit estimate.
Another aspect of drawdowns to keep in mind is that the catalysts that lead to corrections can be relevant factors. A study by MSCI finds that drawdowns can be defined by one of four types of catalysts: macroeconomic, fundamental, leverage/liquidity and noneconomic.
The current correction can reasonably be categorized as a macroeconomic event, which has certain features in the historical sample, including: a tendency for drawdowns to unfold relatively slowly but suffer deeper drawdowns than market declines triggered by the other three factors. Based on analysis since 1946, MSCI reports that the average macroeconomic drawdown is roughly 25%.
On that basis, the S&P 500 drawdown to date is only about a third of way through the process of reaching a trough, assuming that the average history for macroeconomic drawdowns holds. Then again, if President Trump changes his mind on tariffs, drawdown risk may turn out to be milder than history suggests.
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