Are U.S. Stock Investors Too Complacent?

by: Acting Man

by Chris Hunter

A Strange Lack of Corrections

Corrections are normal features of stock markets. The current rally on Wall Street is an outlier. It's seen an usually low number of corrections… and what corrections there have been were unusually mild.

From Andrew Lapthorne, a quant working at investment bank SocGen:

"The number of 1% down days for the S&P 500 in any given year has averaged 27 since 1969; the S&P 500 has seen just sixteen 1% down days over the last 12 months. It has now been 468 days since a market correction of 10% or more, the fourth longest period on record, and, as we show below, the annualized peak to trough loss has only been 5% compared to typical annual drawdown of 15%."

The following chart from SocGen says it all. It shows the maximum peak-to-trough losses for the S&P 500 incurred over a one-year period going back to 1970. As you can see from the far right of the chart, volatility is far below normal.

Volatility plummets. Source: SocGen

This is part of the reason why so many "mom & pop" investors are jumping back into U.S. stocks, despite unattractive valuations.

As Yale economist Robert Shiller points out in his classic book on bubbles and crowd behavior, Irrational Exuberance:

"… people tend to make judgments in uncertain situations by looking for familiar patterns and assuming that future patterns will resemble past ones, often without sufficient consideration of the reasons for the pattern or the probability of the pattern repeating itself."

Most investors can't handle real volatility. They panic when markets crash… sell at, or near, bottoms… stay in cash for too long afterward… and invest in stocks only when headlines turn rosy again.

This is usually disastrous. Because, as anyone who understands the phenomenon of mean reversion will tell you, the longer something remains an outlier, the more likely it is to revert back to the average.

In this case, it means the longer U.S. stocks go without a meaningful correction, the more statistically likely a meaningful correction becomes.

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