A Response To A Friend's Question

I've been dealing with a bunch of work issues that have kept me away from my blog this week.  I did have time though to respond to a question a friend sent me asking about the possibility of a 20-30% correction in the markets in the next five years.  The question was in response to some article he'd read that noted many of the gauges reportedly used by Warren Buffet show the market historically overvalued.  Please note that I don't know what article he's referencing.  

Here's my response:

"I will tell you that at some point over the next 5 years there is a very high probability we'll have a market correction that has the potential to be between 20-30%.  The historic volatility of the market is around 15%, meaning that in any given year there is a very high probability of a stock correction around 15%.  We saw on average about an 8% correction in May for most US indices which therefore means many stocks went down more than that.  At 3,000, the S&P 500 experiencing a 25% correction would  take the index back to 2,250.  That would take the market back to about where it was in early December 2016.  Note though that we were around 2,350 in December of 2018.  If you had that kind of drawdown you'd basically have the market back to the lower end of the range we've been in for about the last two years.  The trick in any decline is trying to figure out if we're in what would be described as a typical correction in prices or a set of circumstances that would morph into something much worse.  To get much worse in my opinion you typically need a few things to happen.  You need an unexpected event or usually the unraveling of a financial bubble in assets.  Some would argue that there's a financial bubble brewing in bonds but if that's the case it is unlikely in my opinion to threaten the financial stability of the world system the way the financial crisis did back in 2007-2009.  Bitcoin is not a bubble.  Cannabis is not a bubble even though these things are in the news all the time.  

As for quoting Buffett, Warren has said a lot of things over the years but I like his comments on volatility and I trot these out for clients in periods of market weakness.  Traders tend to love volatility but investors hate it when it leads to a decline in their accounts.  Presumably nobody minds volatility when stocks move higher.  Here you go.

'The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities — Treasuries, for example — whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatilethan cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskierinvestments — farriskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk.  Popular formulas that equate the two terms lead students, investors and CEOs astray.”

*Long ETFs related to the S&P 500,  in client account and personal accounts, although positions can change at any time    We reserve the right to change these investments without notice on this blog or via any other form of verbal, written or electronic communication.