When Is It 'Safe' To Invest In Stocks After Corrections?

Summary

• Regular investments into the market mechanically buys more (less) when prices fall (rise), relieving you of the task of estimating timely moments for investing.
• History suggests that when the S&P 500 falls 20% from its previous peak, there’s usually more pain to come before the market finds a bottom.
• If you’re highly risk-averse, you might look at SMI and wait for the index to bounce to a relatively high level.

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The answer depends on how you define “safe.” That’s a long conversation because every investor has a unique risk tolerance, time horizon and investment objective. What appears “safe” to you could frighten the hell out of your neighbor. Despite the caveats, we can at least start to think about how the odds stack up when the market takes a dive by crunching some numbers.

Perhaps the first observation is that that taking advantage of sharply lower prices is usually a good choice. Because prices move inversely to expected return, buying stocks after, say, a 20% haircut equates with investing at a time when expected return has jumped by a comparable degree. Of course, there’s a time factor to consider. Realizing the higher expected return will (probably) take years.

A reasonable way to smooth out the noise is dollar-cost-averaging. Regular investments into the market mechanically buys more (less) when prices fall (rise), relieving you of the task of estimating timely moments for investing.

If you’re inclined to be clever, a first step might be looking at how drawdown informs expectations. For example, the S&P 500 Index is currently nursing a 20% drawdown (as of June 29). Declines of that magnitude or deeper are commonly labeled as “bear markets.” More importantly, history suggests that when the S&P 500 falls 20% from its previous peak, there’s usually more pain to come before the market finds a bottom. On that basis, the odds don’t appear to be in our favor at the moment that the worst has passed, or so history implies.

Another way to gauge how the current correction compares with its predecessors is by comparing (in Z-scores) how the market’s current 50-day average less its 200-day average stacks up. Let’s call this the Peak Risk Index. By this measure, the slide is about as deep as it gets via the historical record since 1960. Does that mean that the worst has passed? Maybe, but this alone is no guarantee that we’re at a bottom. What it does tell us is that the magnitude of the decline, so far, is quite steep in relative terms. Nonetheless, there’s no assurance that a market that appears to have fallen off a cliff can’t stay depressed, or go lower still. That said, if your risk tolerance is relatively high you might be inclined to interpret the data as a signal for betting on a bounce.

Finally, let’s look at a somewhat more-nuanced version of the Peak Risk Index in search of a more robust reading of how the market correction compares. In this case, we’re looking at a 7-factor analysis of the S&P 500’s degree of directional bias – the Sentiment Momentum Index (SMI). For design details, see here.

The main takeaway: the market’s dive, although relatively deep, has yet to reach the maximum depths previously recorded. That’s a basis for remaining cautious for thinking that the correction has run its course.

If you’re highly risk-averse, you might look at SMI and wait for the index to bounce to a relatively high level. In a follow-up post, I’ll look at the history of such bounces for deciding when it’s truly “safe” to go fishing again. The obvious drawback: the “safer” the outlook, the more you leave on the table in terms capturing relatively higher expected returns. Then again, waiting for a bounce minimizes the risk that you got in too early. Therein lies the art of investing: balancing risk and return. There’s no right (or wrong) answers, but there are countless variations in risk tolerance, which is to say countless ways to interpret the numbers.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Comments

[O. Young Kwon]

"Therein lies the art of investing: balancing risk and return." (From text) It's true. Both PRI and SMI are the science part (70%). The remaining luck (30%) is "ART."

[apolitical]

Thank you again Mr. Picerno.
I am starting to think that the COVID spike, 1st qtr 2020 to est 4th qtr 2021, in the market was FED exuberance supporting excessive margin accounts. The markets may stabilize around pre-Covid (1st qtr 2020) levels. As to when to start buying, stay focused on 5 yr future growth similar to pre-Covid times.
Mr. Picerno, might I suggest using percentile distributions of the chart data instead of the raw charts. One may find that the current levels are in the P5 range, i.e. only 5% of the historic data has been at the levels today.

[fujilomi]

Dollar cost averaging the SPY will probably work long term. However, it will be scary in the current environment so you MUST not panic if you dollar cost average and it is best if you are young and have a LONG time to do it. It might not work so well if you are old with limited time or have limited funds to commit. In the shorter term, don't fight the charts, don't fight a hawkish FED, and don't fight a Perfect Storm of bad news like a slowing high inflation consumer based economy with consumer sentiment at all time lows and consumer sentiment not much better. Not surprising with the 58% have not majority living paycheck to paycheck with little or no savings and worse yet outstanding loans struggling with increasing prices for food, utilities, rent and gasoline. And even the have minority feeling less wealthy with both sides of 60 40 getting whacked.

[McGeno]

The sky is falling, the sky is falling! everybody knew this pullback was coming. Is analysis prudent? Of course. Is the pullback "unprecedented" as some commenters suggest. NO! Outlandish P/E ratios are being reeled in as the market deals with global and domestic political strife. Stay invested, and collect then reinvest your dividends. Buy good companies in small chunks and stop searching for a bottom. The bottom will not be apparent until we are well past it. The Dotcom and the credit crisis of 2008 were far scarier than what we are dealing with today. Those who stayed the course through those troubled times were rewarded handsomely.

[FrankTrades]

Interesting comments. I suggest to you that the entire market is being repriced. Leaders in the eventual recovery will be the stronger companies but not necessarily those who are being currently pursued.

[FrankTrades]

I think the standard expression is “when there’s blood running in the street.”

[Manzanita Research]

This bear market is nothing like any I've seen before. The fall is slow and steady, and every dip seems to excite investors as they snap up the same old momentum stocks looking at the former highs and counting their riches in anticipation of them being reached again. I sense very little panic whatsoever. While it's possible there'll never be a VIX spike and the market will just snap out of it and climb again -- that would surprise me. In the end human psychology does not change and that is what drives the ends of bull and bear markets so for now I still think a capitulation moment that is lacking will come.

*** post script. I know a fair number of former growth stocks are down 80 even 90% but that happened before the bear market began in earnest. Some think these former high fliers will recover first but I'm not so sure. The quality ones making money yes they will recover, but many are just as worthless as the dotcom stocks of a few decades ago. Other people note $ARKK and similar innovation concept stocks didn't make a new low when the major indexes did recently. Maybe those ARKK type stocks have bottomed but I see little reason for those stocks to go up in a meaningful and sustained way anytime soon. I keep an open mind but I find it hard to believe SPX or QQQ have reached their lows in this bear.

[Felloni]

@Manzanita Research On the ARRK point I actually agree, personally I think Cathy is batshit crazy however most of her holdings have been hammered and many of them are now starting to make decent money. Even the likes of ZM which went from zero to hero and back to the floor actually trades at decent mulitples and is earning free cash flow - its a good example of a stock that has really fallen out of favour. I havent been through all of her holdings however comeing out one level proporionately we are seeing many of those stocks being quiet resistant when we see these bigger drops.

Agreed that the move down has been strangely orderly, there have been a few big days but rarely have we seen 1000 point move on the DOW. I suspect a painful bleed lower. Its hard to see a reason for buyers to step in yet however if the SPX drops another 10-15% I think the buyers will come in with volume

[Felloni]

I dont know what its good to buy stocks .. this is uncharted waters - inflation, war, supply chain issues, global growth slow down, energy costs keeping inflation and transport costs high.

Then we have central banks hammering away with a blunt tool called interest rates, the lagged effects of this blunt tool and the fact that inflation is multifaceated .. the risks of 'over tightening' and pendulem swings are very high.

Some recessions play out for a grind lower for years, we are now in unprecidented times where the Fed is hiking faster and by more than ever before. Buggered if they do or don't really - I have no idea where it ends however high volatility will remain into 2023.

On the flip side, there are some great companies out there and they are getting arguably more affordable - I am reluctant to say cheap as forward earnings questions are becoming more aplified and many companies are in belt tightening mode. What could change all of this: a break through in the Ukraine war would help alot however I am not holding my breathe for that any time soon.

Then I look at the US 10yr, which appears to be stubbornly low. Maybe inferring a less hawkish view than the equities market is taking - Idk!

Bottom line: I have no idea when its safe to buy, I think the Fed has a major challenge on its hands with a blunt tool, great companies on offer however they might get alot cheaper, forward earnings are looking more and more challenged despite analysts mostly being upbeat, volatility to remain high to the end of the year - we could be in for a contiual orderly side lower into the year end ... but thats just a reasoned guess until something structural changes