Will there be a market correction in 2018?

Historically, in any year, a stock market investor has roughly a 40% chance of experiencing a stock market correction—but that’s only part of the story. Vanguard Global Chief Economist Joe Davis says trying to time the market is a game no one wins and that maintaining a disciplined strategy for the long term is the smart move.

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Rebecca Katz: So our next question, and again, it’s sort of predicting the future; but it is in terms of probability. We have a question from Carsten in Perkiomenville, Pennsylvania, who says, “What is the probability of a major—meaning maybe 15% or more—negative market correction in the stock market?”

Joe Davis: Well, you know, we actually recently [put out research, Vanguard economic and market outlook for 2018], it’s on Vanguard’s website, that actually quantifies that risk. So I’ll show two numbers to answer the probabilities.

Historically, in any year, a stock market investor has roughly a 40% chance of realizing or experiencing a stock market correction, which I will define as 10% decline or more. They can be worse, but usually a bear market, which is 20% or more say in the S&P 500, that’s typically and almost inevitably associated with recession. So the bigger the fall, the worse the economic outcomes. But to the person’s question around correction, I’m going to use 10%, historically it’s been 40%. Given how we model future stock returns and the distribution and given how strong performance has been, the level of interest rates in the world economy, and the valuation—say it’s the price of stocks relative to the earnings being accrued and generated by companies—that probability has risen and is now roughly 70%. So I’ve been at Vanguard 15 years. They’re among the highest probabilities that we would have generated.

Now, again, to be clear, I think it’s important to provide, and I would encourage everyone, if they’re interested, to read that report. There’s things you can do about it. One is those probabilities are less for investors that have global diversification in the portfolio. So if you have not just exposure to U.S. equities but global, European, Asia, emerging markets as well, those odds fall to 60%. Again, normal is 40%. This is why one invests in equities, because if there was always generally a low risk for corrections, then why would I hope to expect a higher return? If I had the volatility of a short-term bond fund, then why would I expect a higher return? So that goes with the territory. And then, finally, having a balance, so those probabilities of having a 10% drawdown or negative return in a year for say roughly a 60% equity, a 40% fixed income portfolio, those are materially lower.

Those cases have always been there for global diversification and balance across stocks and bonds, but they are becoming more so. Those tradeoffs are even more pointed now, in part because of the very strong performance of the U.S. equity market over the past several years.

Rebecca Katz: I think one of the challenges with that probability is that we probably have many viewers who are thinking, well, goodness, if I’ve been on the sidelines or I have money to invest, maybe I should wait or do something different. But isn’t the challenge always that you don’t know, maybe it is not an if, it’s a when. But you don’t know when, and you also don’t know when a rebound might come; and we saw that after the global financial crisis.

Joe Davis: Yes, I mean I can tell you what I’m personally doing, and I’m aware of all the data helping to have generated these statistics. I’m looking through it. I think ultimately that 70% number that I’m associated with is part of the reason why we just have a lower central range of expected returns. But I also know that the expected returns on the stocks in my portfolio are higher from the fixed income returns that are going to be generated in my portfolio. And if I have an objective to retire someday, my wife and I—

Rebecca Katz: We’re not going to let you.

Joe Davis: To save for my children’s college education, I am sticking to the plan because, personally, if Joe Davis tries to get too cute and try to time this thing, not only would—I mean, first of all, no one would be able to do that—but even if I thought I could do that, you would have to answer three questions. One is what is the signal that you’re going to get more defensive in the market; and just as importantly, when are you going to go back in? Because roughly 50% of the stock market’s returns over the long period of time come in three or four days of the year. So it’s very concentrated. The peaks can be sharper, so you would have to get it right both at the exit and at the reentry point.

And I have heard stories of investors, in part, because of the trauma from 2009/2010 are still not fully invested in the market. So I think you would just want to think through that arithmetic and how confident you are. I don’t think many investors think that they’re going to be that nimble in doing that.

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