(02/14/14) Corrections: Historical Observations

History shows us that a new 5%+ correction occurs on average about every seven months during bull markets. Studies also show that a correction turns into a greater than 10% decline about once every two years, observes Jim Stack, market historian, money manager, and editor of InvesTech Market Analyst.

The last time this bull market saw a 10%+ pullback was in 2011 (although there was a 9.9% sell-off in mid-2012). Thus, it would be within the realm of expectations to see a 10% correction at some point this year. The possibility is even more likely, given the typical volatility and weakness in mid-term election years.

Although corrections usually come frequently, they don't last long. Even larger corrections with 10%+ market declines are often brief, lasting only a few months...and losses are recovered quickly.

Since 1974, there have been six bull markets, and those have seen 13 market corrections that exceeded 10%. We looked at these corrections to determine the number of months after the low that it took the market to recover its correction losses and hit a new bull market high.

The recovery time for these 13 corrections of 10%+ had a median duration of 2.3 months. The shortest such correction was 29 days in 1997, and the longest was 1.5 years during the high inflation period from 1976 to 1978.

However, these deep corrections rarely lasted more than four months. The median time it took the S&P 500 to fully recover after a 10%+ correction was 3.6 months, with recovery time as brief as 32 days in 1999. With the exception of the extended 1976-78 decline, losses in all these larger corrections were fully recovered within six months.

During corrections, cyclical stocks are the most vulnerable, but that doesn't mean they should be sold to avoid losses. In fact, maintaining a balanced sector strategy will speed your recovery.

We looked at the sharp change in sector leadership that occurs once the correction low is in place, to determine the most and least resilient, based on their median losses during 10%+ corrections.

Defensive stocks are the clear winners, with the non-cyclical Utilities, Staples, and Telecom sectors outperforming the S&P 500 at least 70% of the time. Conversely, the cyclical Financials, Industrials, and Technology sectors tend to suffer the biggest losses.

After the market reaches the correction low, however, it's these vulnerable stocks that typically lead the recovery. Financials, Industrials, and Technology are among the leading recovery sectors in the three months following a correction, outperforming the S&P 500 the majority of the time.

Meanwhile, the non-cyclical stocks also recover, but usually lag the Index as it moves on to new highs. Bottom line, if you panic and sell all your cyclical stocks during a correction, you have eliminated a substantial part of your recovery potential.

Overall, market corrections are fairly frequent occurrences during a bull market, but they should not significantly affect your investment strategy. Actually, these pullbacks can be healthy, as they control speculation and exuberance, and may help extend the life of a bull market.