2022's market correction shouldn't be cause for alarm

Following two years of an extraordinary bull market, Q1 2022 spooked investors as the market opened the year with an immediate market correction. This has caused concern among investors and has induced some “experts” to predict further drops or even an extended bear market. A market correction is just as the name implies, a 10-20% drop in stock prices that occurs when a bull market has gotten ahead of itself. If losses begin to creep above 20%, we are no longer in a correction – we are entering a bear market. We have seen this script play out many times before, and each one has its own particular nuances that make it unique. Every market decline is unique, yet not something that requires a complete change in one’s overall investment strategy.

Investors are human beings with many fears and desires that influence their overall investment decisions. Many times, these decisions are driven by a prolonged sense of what is “normal.” For instance, during the technology crash of 2000-2002, the Nasdaq dropped approximately 80% over three years. Investors generally believed that the negative returns would continue into the future. Conversely, during the past three years (January 1, 2019 – December 31, 2021), the S&P 500 had cumulatively gained 100%. The two time periods are obviously significantly different. Nonetheless, overall investor sentiment for both time periods was similar.  Investors feared that the market would drop. Why would investors be concerned that markets could continue to fall in both scenarios?

The answer lies in investor behavior. When markets rise for an extended time period, the general consensus is that the markets may crash soon after. Conversely, when markets decline for a lengthy time period, many assume that the trend will continue. In other words, the mind is pre-programmed to think in terms of a worst-case scenario. For most investors, fear (loss avoidance) is a stronger emotion than greed.

Currently, there is a lack of confidence in the markets, which has been exacerbated by historic market events. In 2008, amid the Great Financial Crisis, the S&P 500 dropped approximately 53%. In 2018, the S&P 500 declined 13% and just two years later in 2020, the index was down 32%.

We all have been riding high for the past few years and may have found ourselves caught off guard by the recent market correction. This serves as an important reminder – market corrections are a natural part of investing.  In fact, in an average year, the U.S. stock market will decline about 10% from high to low, with an additional three declines of 5%.

Keep in mind that broad indices like the S&P 500 can be skewed to a handful of stocks. For example, approximately 30% of the equity weighting of the S&P 500 is composed of only ten stocks. This means that out of 500 stocks, only 10 are responsible for 30% of the index return. This is clearly not a representation of a diversified portfolio or of the real economy. The S&P 500 is essentially comprised of U.S. Large Cap Growth and Large Cap Value stocks.

Diversification, although not an overly exciting strategy, can be one of the most effective tools against market volatility. When looking at current market valuations and investment options, we see the 10-year U.S. Treasury yielding less than 2%, and a 30-year bond yielding just over 2%, as of, which is not very competitive to the historic returns that the stock market has provided over long periods of time.

It would be difficult for most Americans to achieve their financial goals with a return of 1.8%. In contrast, at the start of the bear market in 2000, the 10-year Treasury yield was over 6% and over 3.5% in 2008.  Those yields were high enough for investors to pull some of their assets from stocks and reallocate into bonds, but 1.8% is much less compelling.  That said, markets are not always rational over short periods of time.

It is important to remember that a correction is not a crash. It is simply a pullback from multiple years of double-digit rates of return. We are not surprised by the 2022 market correction. In fact, it can provide opportunities for the disciplined investor.

Transform a downturn into an opportunity

The first thing we advise unequivocally is don’t panic. Trying to predict when a market correction or a bear market will happen or what future market performance will be is an exercise in futility. First and foremost, emphasize with your clients to use these opportunities to create tax losses (i.e., tax loss harvesting). It is a powerful way of offsetting taxable gains by creating losses. When an investor takes advantage of a depressed stock price by selling it, that realized tax loss can be used to shelter future taxable gains. Therefore, the investor pays less tax dollars to Uncle Sam, which can result in significant savings.

When equities are depressed, allocations can shift away from targets, meaning a 50% equity/50% bond portfolio can become a 45% equity/55% bond portfolio. It may be time to consider rebalancing portfolios by selling bonds and purchasing equities at discounted prices. Therefore, if markets continue to drop, which happened during the 2008-2009 financial crisis, clients can expect rebalancing to continue, meaning the buying and selling of bonds and equities would continue at further discounts. While this technique can seem counterintuitive, when utilized during market downturns, history shows that an investor may recover quicker than if no action was taken.

 Diversification is key

In the current environment, there are many uncertainties surrounding market conditions – interest rates, Fed monetary policy, supply chain issues, inflation, COVID-19, Ukraine/Russia tensions – just to name a few. These uncertainties, paired with a highly-valued market, have created a surge in volatility. Volatility, although unnerving, can present various opportunities. Market downturns are both a necessary and normal part of investing.

After decades of experience as an investment advisor, I have yet to find even one person or firm who can consistently predict short-term market movements.  As such, I prefer to use diversification as a means of risk reduction instead of market timing. Always remember, it is TIME IN the market that matters, not TIMING the market.

Rob Conzo is CEO of The Wealth Alliance ($1.2B AUM).