Is It Time for a 5% Pullback?

Monday’s big down day was a harsh reminder of how markets actually can produce volatility. It was the worst day of the year for the Dow and only the second drop of 1% or more for the S&P 500 Index in just over two months.

As we noted recently in Three Things That Worry Us, there are many reasons to think that after more than a 90% rally (and virtually a double on a total return basis), the S&P 500 could finally be ready for a break. From less stocks participating, to weak seasonality, to a lack of bears, to typical choppiness during year two of a bull market, the summer months could be ripe for an eventual pullback (down 5-9%) or even a 10% correction.

August and September can be trouble

See enlarged chart.

“The truth is investors have been very spoiled by the recent stock market performance,” explained LPL Financial Chief Market Strategist Ryan Detrick. “Incredibly, we haven’t seen as much as a 5% pullback since October. Although we firmly think this bull market is alive and well, let’s not fool ourselves into thinking trees grow forever. Risk is no doubt increasing as we head into the troublesome August and September months.”

As shown in the LPL Chart of the Day, the average year sees three separate 5% or more pullbacks for the S&P 500 with not a single one happening yet in 2021. This doesn’t mean a 5% correction is directly around the corner, but note that most stocks are actually already down as much as 10% off their recent highs, suggesting the internals of the market are a tad weak and risk is higher than normal.

No 5% pullbacks since October 2020

See enlarged chart.

Looking at 10% corrections, the S&P 500 has averaged exactly one a year since 1950. Of course, with the historic volatility last year we saw four separate 10% corrections, though there hasn’t been a 10% correction since March 2020. Again, this could be getting long in the tooth after the 90% plus rally from the lows.

Corrections happen once a year on average

See enlarged chart.

Overall, worries over inflation, yields, the Delta COVID-19 variant, peaking economic data, or something else will get the headlines for any market weakness. We know that year two of bull markets can be choppy and frustrating, but the truth is earnings remain extremely strong, justifying stocks at current levels. It is just that sometimes stocks need to catch their breath, and we wouldn’t be surprised at all if that happened over the coming months.


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