It’s finally here… A correction. On September 20th, the S&P 500 closed at an all-time high of 2930.75. Little more than a month later, intraday on October 29th, the benchmark index hit a low of 2603.54, marking a peak to trough decline of -11.16%. Then into the close, we saw a significant increase in volume, as buyers came rushing in. The S&P 500 closed down for the day, paring losses, at2641.25, a decline of -9.88% from our highs.

By definition, a correction in the stock market is a loss of 10% or greater. Such losses are historically commonplace, yet each time they present themselves, the mettle of investors is tested. So here we are again, and for the moment, fear has taken hold, and the markets have moved lower. It’s times like this when we all need to take a step back and put things into perspective. Making a critical mistake during unstable market environments can be extremely detrimental to the long-term performance of the individual investor.

Each year, Dalbar releases their “Quantitative Analysis of Investor Behavior,” highlighting the performance of the average individual investor versus various benchmarks and over multiple time periods. They’ve been publishing this report since 1994, and while over the years the numbers may slightly change, the underlying theme remains the same. The average individual investor significantly underperforms the market.

Over the past decade, the average equity investor has only managed to produce an average annual gain of 4.88%, versus 8.50% for the S&P 500. Notice, this is not an aberration, as underperformance by individual investors can be observed overall trailing periods.

There are many factors that contribute to the historical underperformance of individual investors, but the most pronounced is the proclivity to allow emotions to have an impact on investment decisions. When markets correct, it can be uncomfortable, and the 24/7 news flow of negative sentiment can often lead us to believe that things can only get worse. History has proven otherwise.

Mark Twain is often reputed to have said, “History doesn’t repeat itself, but it often rhymes”. Over the past ten years, we’ve experienced double-digit losses in the equity markets seven times prior to our current correction. Each time there’s been a different reason why the markets sold off, but the end result of the correction was the same. Not only did markets recover and go on to make new all-time highs, more importantly, on every occasion the asset classes and underlying sectors of the markets that held up the best during the declines have significantly lagged during the following recovery.

In order to be able to put recent declines into perspective, we first need to know where we currently stand. On a daily basis here at Polaris Wealth, we track the performance of a number of the most prominent Exchange Traded Funds. These ETFs represent both U.S. and International equity markets, across both Growth and Value styles, up and down various capitalizations, and across various underlying sectors. We also track the underlying performance of various credit qualities and maturities of Fixed Income, as well as some Alternative asset classes. This provides us with an excellent 30,000-foot-view of the markets and helps us understand how larger global macro influences are impacting the investment landscape. What we are looking for is relative divergences and changes in underlying market trends; opportunities we can exploit within our portfolios. Sometimes these changes happen rapidly, as they have during our recent sell-off. At other times underlying rotations in the market may be more gradual. This daily analysis provides us with keen insights into how we might best navigate our current environment.

Over the past several weeks, equity markets the world over declined rapidly. Whether investing in Domestic or International stocks, in Growth or Value, or any possible size company – these losses were widespread. Traditional Fixed Income has held up better during these declines, but as you can see in our PGFG ETF Daily Market Barometer, for the year the average Fixed Income investor has been at a significant disadvantage. As interest rates rise, the prices on existing bonds fall. In an environment where the Fed continues to reassure us that they intend to continue to raise rates, it should come as no surprise that this has not been a segment of the market we have favored.

The only segment of the market that held up well during our recent downturn has been the Utilities and Consumer Staples sectors; the two worst performing sectors of the markets over the past several years. Point being, no one owned them; certainly not to any large degree. Ironically, the very sectors and segments of the market that have been our best performing year-to-date and over the past several years are the sectors that have retreated the most. This includes the Technology and Consumer Discretionary sectors, our two greatest contributors to portfolio performance leading into this downturn.

The sentiment is negative at the moment and during times like this, it can be easy to question one’s respective discipline. But if history indeed rhymes, investors would be wise to pay close attention. By taking a look at the various double-digit declines over the past decade, what should be most evident is the opportunity cost of getting caught chasing the asset classes and sectors that have held up the best during corrections. The headlines that move the markets during moments like this will always change, but the outcomes remain the same.

Recovering From the Depths of the Great Recession

If you were investing in the stock market back in 2008, this is likely a time period you will never forget. This was our proverbial “black swan” recession and the worst calendar year return in the U.S. equity markets since the Great Depression. From January 1st of 2008 to the market close on March 9th, 2009, the S&P 500 lost more than -46%. Amazingly, during this same period, the iShares 20+ Year Treasury Bond ETF (Ticker: TLT) was up 14.09%! Talk about a flight to safety…

What I think is the most notable takeaway here though is how these various segments of the market recovered, before topping out again on April 22nd, 2010. After remaining positive during the Great Recession, during the recovery TLT lost nearly -8%. While all sectors incurred significant losses during this period, the traditionally defensive sectors (Consumer Staples, Health Care, and Utilities) held up marginally better. But during the recovery, these sectors were only up 36-44%, compared to the likes of Industrials, Consumer Discretionary, and Financials that were all up more than 100%.

Recovering From the Flash Crash of 2010

Coming into 2010, investor confidence was still very much shaken from everything the markets had been through during the Great Recession. Many were waiting for the next shoe to drop, not fully embracing that we were truly on the road to recovery. On April 23, 2010, we reached our year-to-date highs in the equity markets, from there confidence slowly began to wane. Then on May 6th, we experienced the “Flash Crash”. During little more than a 30-minute period of trading in the afternoon, the Dow Jones Industrial Average inexplicably dropped more than -9%. Understandably, the event spooked investors. From 4/23 through 7/2 the SPDR S&P 500 ETF (Ticker: SPY) declined more than -15%, then from 7/3 until our next market high on 4/28 the following year, it rallied more than 35%, easily recouping all losses. During that two-month decline, there was not a single global equity market, nor market sector to post a positive rate of return. However, all maturities of U.S. Treasuries were up, led by a more than 12% advance made by TLT.

Once again, during the recovery of the defensive sectors – Consumer Staples, Health Care, and Utilities held up much better than the S&P 500, or other underlying sectors. But during the recovery that followed, they were only up 21-27%, as compared to the leading sectors that were up roughly 45-63% (Energy, Materials, and Industrials). Notably, TLT lost over -4% during the recovery.

Recovering From the 2011 S&P Downgrade of U.S. Long-Term Debt

2011 is remembered as a difficult year in the global equity markets. The only major index to generate a positive rate of return was the S&P 500, up 2.1% (and that was all dividends). Starting in late April, equities began to gradually decline. On Friday, August 5th, shortly after the stock market closed for the weekend, the S&P rating agency announced that they were lowering their credit rating on long-term U.S. Treasuries from AAA to AA. This sent the markets into a tailspin. All told, from April 29th to October 3rd SPY was down more than -18%, and the international markets were down even worse. From a sector perspective, only the Utilities Select Sector SPDR ETF (Ticker: XLU) generated a positive rate of return, up 1.28% for the period. Once again, while equity markets were faced with significant losses, all maturities of U.S. Treasuries gained ground, with TLT up nearly 35% in little more than 5-months!

After bottoming, over the next 6-months, the equity markets went on to make a strong recovery. From 10/4 until 4/1/2012, SPY gained over 29%. Consumer Staples and Utilities held up remarkably well during the sell-off, but when the markets recovered they were only up 9-18%, versus gains of over 30% in five other sectors (Consumer Discretionary, Financials, Industrials, Materials, and Technology).

Recovering From the Fed Announcement – Holding Off on More QE

2012 produced double-digit gains for the global equity markets, but not without having to overcome a mid-year double-digit decline in international equities (and a high single-digit decline in the domestic markets). In early April, the Fed announced that they were going to hold off on any further quantitative easing measures unless the economy showed further signs of weakness. At the time, many investors had been counting on further measures as a catalyst for future gains in the stock market. Over the next two months, SPY dropped nearly -9%, while the iShares MSCI EAFE ETF (Ticker: EFA) lost nearly -15%. During this period high-quality bonds continued to post gains, and TLT was up more than 15%. As fears subsided, global equities posted strong gains, going on a dramatic run of more than 3 years before our next correction.

From June 5th, 2012 up until July 19th, 2015 SPY gained nearly 70%. The PowerShares Nasdaq 100 ETF (Ticker: QQQ), was up even more dramatically, with a gain of nearly 95%. Conversely, TLT which had been up strongly during the pullback went on to lose -4%. Utilities were the only sector to generate a positive rate of return during the decline, up 2.3%. But during the recovery, they only gained little more than 36%, as compared to the returns in other sectors as high as 128%!

Recovering From the China Yuan Devaluation and Increased Fears Over Greece

From the middle of 2012, up until mid-year 2015, we were able to avoid double-digit losses in equities in the U.S. Then China went out and did the unthinkable, devaluing the Yuan. At the same time, fears began to increase regarding how the insolvency of Greece would affect the global economy. From July 20th, 2015 to August 25th the S&P 500 dropped nearly -12%. Not surprisingly, during this time TLT posted a gain of 4.4%. All sectors were negative, but Utilities performed the best, -3.08%.

It didn’t take long before our next correction just a few months later, starting off the New Year in 2016 with a bang, but in the few months preceding that, the S&P 500 recovered more than 10% from the lows, while TLT lost -1.3%, and Utilities only gained 5%. This compared to gains of nearly 15% and 11% respectively for the Technology and Consumer Discretionary sectors.

Recovering From Growing Concerns over the Economy and Chinese Debt

In 2016, the S&P 500 got off to its worst start to a calendar year in history. We began the year with growing concerns over the domestic economy and worries about how bloated Chinese debt could potentially topple the global markets. From 1/1/2016 to 2/11/2016 SPY lost more than 10%. At the same time, EFA lost nearly 13%. Not surprisingly, while equities struggled during this period, U.S. Treasuries were up, led by a more than 10% gain in TLT.

Once the bottom was put in, global equities went on a strong rally that lasted for nearly two years, until January 26th, 2018. During this time the S&P 500 gained over 63%, while the Nasdaq rose by more than 80%. While equity markets took off, Treasuries struggled in the face of rising interest rates, and TLT declined -2.9%. Utilities and Consumer Staples were the best performers during the correction, up 5.6% and down only -2.2% respectively, but over the next two years, they only gained 19% and 25%. This compared to five other sectors up between 64-96% (Financials, Technology, Industrials, Materials, and Consumer Discretionary).

Recovering From Inflation Fears, Interest Rate Concerns, and a VIX ETF Collapse

Earlier this year the U.S. equity markets reached all-time highs on January 26th. This came after nearly two years of strong gains in the global equity markets, and after the S&P 500 had notched monthly gains for all of 2017 (the first time in the history of U.S. capital markets), while also recording record low volatility. The markets were also among the most overbought than any other time in history. Coming into the year we were faced with growing concerns over potential inflationary pressures, coupled with the Fed telegraphing increased interest rate hikes, and then we had the collapse of an inverse leveraged volatility Exchange Traded Note. Having gone more than two years without a pullback of more than 10%, we were overdue.

From January 27th to February 8th, the S&P 500 declined by 10%. Unique to this time period versus the others we have covered is that this time there was literally no place to go (other than cash) for safety. Treasury ETFs and defensive sectors also traded down.

From February 9th to September 20th the markets went on a strong rally, again setting new all-time highs. From the lows of the year, the S&P rebounded nearly 15%. Technology, Consumer Discretionary, and Health Care led the way – up 21.9%, 18.2%, and 17.6% respectively. These are sectors we have favored, and we were rewarded for it. Consumer Staples performed the worst during the recovery, up only 4.5%, and the Aggregate Bond market was essentially flat.

Now What?

I began this article by providing a 30,000-foot-view of our current market conditions, highlighting various segments of both the equity and fixed income markets. From the all-time highs reached in September, the S&P 500 declined as much as 11%. On the very day the markets technically moved into “correction territory” we witnessed extremely strong buying action coming into the close, significantly paring our losses. To this point, that has at the very least sparked a relief rally, and at best we may well again be on our way to forging new all-time highs. Time will tell but suffice it to say corrections are not uncommon, and I would contend in order for the markets to move on and again make new highs, they are very much necessary. Pull-backs reset valuations and expectations, and more importantly for those with discipline, they provide opportunity.

When we look at things from a historical perspective, it’s easy to put our recent short-term losses into perspective. This time around, the downdraft happened rapidly and without warning, leaving little opportunity to play defense. At a time when growth in our economy has continued to remain strong, one should not have been reasonably expected to see it coming. What sold off the most were the very things that had been doing the best. At this stage, now is not the time to be chasing the more defensive sectors like Utilities and Consumer Staples, let alone traditional fixed income. And while maybe we can’t unequivocally prove that it was Mark Twain that uttered the notable phrase, “History doesn’t repeat itself, but it often rhymes”, history has repeatedly proven that discipline during more adverse times in the market is paramount to achieving long-term success.

This website is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Polaris Wealth Advisory Group unless an investment management agreement is in place.