Is the Next Market Pullback Imminent?

It’s been a noteworthy year for the U.S. equity market. Beyond reaching record highs, the S&P 500 is on track to post its 9th consecutive year of gains. The only other time this happened was 1991 through 1999 on the run up leading to the tech bubble. Furthermore, the index hasn’t had a 3% drawdown in 238 days, the second longest streak since 1928, and is four days away from breaking the all-time record.

Source: Bilello, Charlie. “Is the S&P the New Money Market?” PensionPartners.com, pensionpartners.com/is-the-sp-the-new-money-market/.

The cover story of this week’s Barron’s – Echoes of the 1987 Crash — exemplifies the recent barrage of articles highlighting fears that the market’s dramatic bull run may be about to end, and even worse, the market may be vulnerable to a significant correction.

Experience tells us these types of articles raising fears of a looming market correction aren’t breaking news. Virtually every conversation I have had with advisors and their clients since 2013 typically included a comment like, “we are long overdue for a market correction,” followed by the question we all want the answer to, “we now the right time to increase or decrease my equity exposure?”

The reason investors are asking the question is because reducing equity exposure too soon or too late can have a profound impact on long term performance.

So, what does it all mean? First, let’s acknowledge the fact that market shocks are inevitable, have been proven to be unpredictable, and are only obvious after they happen. The amount of time and energy put into forecasting something that is unpredictable never ceases to amaze me. Having observed the lunacy of the forecasting game for the last 33 years, I have yet to find any source that has consistently been right.

We would be the first to admit that we can’t accurately predict when the next market correction will happen, and we don’t think anyone can. We believe it’s much more important to know how to respond when it does inevitably happen. Our portfolio research and investment experience has lead us to use risk to allocate capital; we believe it is the most effective way to respond to turbulent markets. Our risk based approach can also enable us to capture the upside when markets are calmer and begin to trend higher.

Source: FactSet. Index: S&P 500 Total Return Index Daily Chart during CY2007.

History has shown that you don’t have to pick the market top (or bottom) to effectively manage risk. The 2008-2009 financial crisis is a perfect example.

The market top occurred in October 2007 and was surrounded by escalating risk; there was plenty of time to respond.
By using risk to determine allocation changes in a balanced portfolio, the rapidly increasing market risk would have suggested a reduction in the allocation to equities. This reallocation would have significantly reduced the magnitude of the drawdown.

At Paritas, we utilize a quantitative, rules-based process to mitigate losses during major drawdowns. We avoid subjectivity and forecasting when making portfolio decisions to help us achieve our primary objective of delivering more consistent, positive returns over time.

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About the author: Douglas Hedley