September has brought about an unusual phenomenon to the stock market… it has stopped going up! Month-to-date the S&P 500 is down about 2%. If the recent pullback seems worse than it’s been, that’s because 2021 has seen a historically strong and calm stock market. Over the last 70 years, the S&P 500 has averaged three 5% pullbacks per year. So far in 2021 there have been zero.
Getting back to “normal”
Getting back to normal has been a big theme in 2021, but the action in the stock market has been anything but. It’s not necessarily a surprise that the stock market has risen, that’s what it tends to do over time, but the lack of any meaningful downside is rare. Stocks typically spend time going both directions, it’s just that the market usually has a two steps forward, one step back, component to it. This is what ushers in higher prices over time but still allows for a two-way market.
Two-way markets are normal. A market that goes one direction with such consistency is not normal. So, with the S&P 500 falling a little bit through the first few weeks of September, it’s not a sign of fear. Rather, it’s a sign that the stock market might be returning to normal. And if that’s the case, what should our expectations be moving forward? Well, as mentioned in the opening paragraph, the S&P 500 typically pulls back 5% three times per year. A 5% pullback from last month’s record high of 4,537 would take the index down to 4,310; that’s about 2.50% lower than the current level.
The likely reaction to lower prices
Now, should we get an additional 2.50% sell-off in stocks it will probably be pretty comical how much fear-mongering will start to take place. Ever since the Covid bottom in March 2020, stocks have been on an unrelenting rally. So it’s been easy to forget what downside looks and feels like. In fact, there hasn’t been a 10% pullback in the S&P 500 since the bottom. In the last 40 years, the index has averaged one 10%+ decline per year. We’re going on 18 months without one.
The logical reason for any weakness we’re seeing in the stock market is simply an after effect of all of the strength we’ve seen thus far. Again, stocks don’t go up everyday, but in 2021 that’s actually been happening. Now, the news headlines can never just say that stocks are going down because they were up too much (maybe they should try that though), so instead you’re going to see two words thrown around in the coming days and weeks: “taper” and “tighten.”
Everyone is going to make a big deal over whether or not the Federal reserve is going to start tapering their bond purchases, and the tightening effect this will have on easy money policy. While it is true that these could be negative sentiment drivers for stocks in the near-term, it’s also true that the market has had ample time to see this coming. In other words, outside of the fed raising interest rates this year (which they absolutely won’t do), it will be hard for the market to be caught off guard by anything fed related.
But…
Our call that the market won’t be caught off guard shouldn’t be construed as us saying that a sell-off is impossible. As we’ve outlined herein, a 5-10% pullback in the S&P 500 would be totally normal. Such pullbacks typically happen a few times per year and don’t usually impede the market from continuing its upward trajectory overall.
Market’s often need a catalyst to pullback, and it’s possible that upcoming rhetoric from the Fed regarding their tapering plans could be that catalyst. Such a pullback would not be a surprise, it would be normal. What you’re not likely to see anytime soon is a free-fall like the one that gripped the market and economy in March 2020, and that’s what we mean when we say the market won’t be caught off guard.
In summary, understand that 2021 has been an exceptional year for the stock market thus far due to how smooth it has gone. There have not been any 5% pullbacks, let alone a 10% one, even though both commonly happen at least once per year. We could be starting one of those pullbacks though as the S&P 500 is down about 2% from its high since September started. And in the coming days there is sure to be plenty of headlines surrounding the Federal Reserve’s plans for tapering their bond purchases which may lead to some short-term concern over a tightening of monetary policy. Even still, the market’s overall uptrend remains well in tact and we expect that remains the case into the fourth quarter.
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