What history reveals about the market sell-off

What was the likelihood of the recent correction?

— -- Anxious investors, concerned that the stock market dipped into correction territory briefly Tuesday, are looking for a compass to guide them.

The Dow Jones Industrial Average plummeted 567 points Tuesday -- 10 percent below its all-time high in January -- and then promptly regained these losses.

The sell-off has increased speculation over how long the bull market can last. Banking (sometimes literally) on the belief that history repeats itself, professional investors use historical market data to make projections.

In considering historical data, it’s a good idea to keep in mind two quotations. The first is from Max Beerbohm, the Victorian-era British humorist and author: “History doesn’t repeat itself. The historians repeat one another.” So do some market analysts.

The second quotation is attributed to Mark Twain (but actually may be a composite derived from multiple authors): “History doesn’t repeat itself, but it often rhymes.” Some analysts mistake rhyme for repetition.

Equipped with these caveats, let’s look at how history answers three MDQs (major dramatic questions) concerning the market’s future and recent past:

How long can the bull run?

History says: Indefinitely. The market ran like a jackrabbit in 2017, when the Dow Jones Industrial Average rose about 6,000 points. Many analysts expect the current pullback to be short-lived because the economy and market fundamentals remain strong. If you view a steeper drop as being more likely because of the magnitude of the last year’s gains, keep in mind that the impact of these gains on long-term performance isn’t huge. Pulling back the camera, we examined the last 50 years of market performance, noting the closing price of the S&P 500 every year and the total price gain over trailing multi-year periods. Of 31 trailing 20-year periods, the one that ended just before this month’s pullback was the third worst in the last half-century. So, if the market rises for many months to come, it would just be catching up to long-term averages.

What was the likelihood of this month’s pullback?

History says: Quite high, and January was the most likely month for a 5 percent or more pullback. Since 1927, the average interval between 5 percent-plus dips has been only 63 trading days. On Jan. 23, the market set a record for the longest stretch without a 5 percent-plus pullback: 395 trading days. And according to history, the market was highly unlikely to go much longer without a significant dip in a year following a stellar year like 2017. Market nerds keep track of the months in which such pullbacks begin. Based on this, they calculated the chances that a pullback in 2018 would start in January at nearly 26 percent, far and away the highest likelihood for any month this year. So history predicted this one.

Does the market drop (and rise) faster and faster?

History says: No question about it. Two new factors are accelerating drops. For one thing, at least before the current pullback, optimistic professional investors had radically changed their normal defensive behavior by cutting back significantly on derivative investments they routinely make against the market to lessen net losses from a decline. A market decline could force them to sell a lot more shares than they otherwise would, driving down values faster — though the pullback is probably prompting them now to resume hedging. Another factor is the rapid growth of exchange-traded funds (ETFs), shares of which can be traded during the trading day unlike index funds. Intra-day trading by holders of ETFs drives values down (or up) faster.

Because similar markets can result from different periods of economic history, basing projections on market history alone can prompt expectations of repetition when rhyme may be more likely. But while historical data is no crystal ball, it offers distinct insights, especially when evaluated along with more comprehensive data.

Taken alone, history can offer invaluable perspective on the present. Try this for perspective: Historically, 5 percent-plus pullbacks on average have occurred two or three times a year and 10 percent drops once every 18 to 24 months.

So the key is to not worry about these inevitable declines. Instead, keep your eyes on the prize: Long-term net gains.

Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry.

Any opinions expressed in this column are solely those of the author.