Drawdowns, corrections, and the risk of recession

Among the most common questions I receive in most years is, “When is the drawdown coming?”  For what it’s worth, rounding out the top five this year are: “How should I position my portfolio based on the likely election outcome?” (Elections don’t matter to markets.) “How concerned are you about US debt?” (I’m not.) “When will markets broaden out?” (Likely when policy eases and growth reaccelerates.) “Who will win the election?” (I don’t know).

The answer to whether a drawdown (a decline of less than 10%) is coming has always been an easy one. Sure. Drawdowns are always coming. Since the early 1980s, there has been a greater than 5% drawdown in the S&P 500 Index in every year but two (1995 and 2017). (1)  Even in this year, which had felt relatively benevolent until the past few days, the S&P 500 Index experienced a 5% drawdown in April before climbing to an all-time high in the middle of July. (2)  For all the excitement around the current drawdown, the broad market is still less than 6% from its all-time high (3), although companies that are disappointing on earnings have fared worse.

On the other hand, corrections (declines of greater than 10%) happen less frequently.  Corrections typically don’t just emerge out of nowhere.  Often, they’re the result of policy uncertainty and/or surprising weakness in economic activity.  The market has currently gone since Nov. 2, 2023, without an official correction, representing a 188-day period of a resilient economy and declining inflation. (4) We appear to potentially now be on the brink of that next 10% decline as the economy weakens (see Friday’s jobs report (5)) and the Federal Reserve passed on lowering interest rates at the July meeting.

S&P 500 Index: Number of days and total return since the last 10% decline

How ominous is it? Admittedly, US growth is below trend and deteriorating, which would suggest taking a defensive approach. However, we would expect the weakness to be short lived as the Federal Reserve eases policy to reinvigorate economic activity. Historically, markets tended to perform well in easing cycles that were not associated with recessions. (6)

Fortunately, we do not see glaring signs that a recession is imminent. For one, there does not appear to be significant excess in the economy (7). Two, corporate borrowing costs relative to the risk-free rate remain below recession levels. (8) Three, the banks do not appear to be tightening lending standards significantly. (9) If the end of the cycle is not imminent, then any near-term drawdown or correction would likely prove to be a short-term deviation on a longer-term advance.

1. Source: Bloomberg, as of 8/2/24. 
2. Source: Bloomberg, as of 8/2/24.
3. Source: Bloomberg, as of 8/2/24. The market peaked on July 16, 2024, at 5667.
4. Source: Bloomberg, as of 8/2/24.
5. Source: US Bureau of Labor Statistics, 7/31/24.
6. Sources: Bloomberg, Invesco, 7/31/24.
7. Source: US Census Bureau. Based on business investor to sales ratios and housing supply.
8. Source: Bloomberg, 8/2/24. Based on the option-adjusted spread of the Bloomberg US Corporate Bond Index.
9. Source: US Federal Reserve. Based on the Senior Loan Officer Survey net percentage tightening lending standards to large- and mid-sized businesses.

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All investing involves risk, including the risk of loss.

Past performance does not guarantee future results.

An investment cannot be made directly in an index.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

The S&P 500 Index is a is a market-capitalization-weighted index of the 500 largest domestic US stocks. 

The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes US dollar-denominated securities publicly issued by US and non-US industrial, utility, and financial issuers.

The Senior Loan Officer Survey is conducted by the US Federal Reserve to provide qualitative and limited quantitative information on bank credit availability and loan demand, as well as on evolving developments and lending practices in the US loan markets.

Option-adjusted spread (OAS) is the yield spread that must be added to a benchmark yield curve to discount a security’s payments to match its market price, using a dynamic pricing model that accounts for embedded options.

The opinions referenced above are those of the author as of August 2, 2024. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.