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When the stock market stumbled earlier this week, you may have been spooked, and understandably so.
The market dip, which was attributed to investors' concerns about the high debt levels of one of China's largest real estate developers, was hard to stomach given the resilient bull market we've seen over the past year, with the S&P 500 up 100% last month compared to its March 2020 pandemic low.
During trading Thursday, the S&P 500 and the Dow Jones Industrial Average were back in the green for the week — but that doesn't mean stocks are out of the woods. Experts have long been warning that a market correction is coming.
Here’s what they say about how the delta variant could impact the long-awaited correction, and how you should prepare.
A stock market correction is coming
There is no way to say for certain whether or not we’re already at the beginning of the correction (generally considered a dip of 10% to 20% in stock prices), but experts say one thing is for sure: it’s coming at some point.
"By historical standards, this bull market is long overdue for a correction," Jim Paulsen, chief investment strategist at the Leuthold Group wrote in a research note at the end of August. "A 10% to 20% selloff is almost certain to occur before long, and it would not be surprising if investors encounter one before this year is over."
Paulsen doesn’t think so. Corrections tend to happen when bond yields have gone up, when fiscal policy is tightening and when corporate profits are struggling — none of which we’re seeing yet, he says. Plus, with September historically being the worst month for the stock market and all the anxiety around an awaited correction, he says it seems too expected right now.
“Normally corrections hit when everyone’s feeling pretty good and then boom!” Paulsen says.
While a correction is long overdue, the drivers of this week’s sell off likely aren’t a strong enough catalyst to be the start of a market correction, says Mychal Campos, Betterment’s head of investing. A more likely driver, he adds, will be when the Federal Reserve tightens monetary policy and makes it harder to borrow money. Federal Reserve chairman Jerome Powell said on Wednesday that the central bank may soon begin to ease up on the stimulus that has helped keep the economy afloat during the pandemic.
COVID-19 could also have a big impact over how a future correction will play out.
Since March of 2020 — when COVID-19 hit the U.S. and the S&P 500 dropped 12.5% over the course of the month — there has been a close relationship between which investments do well across all financial markets and whether virus cases are trending up or down.
While corrections usually do most of their damage in just a few days, they tend to last several weeks — and, as we’ve seen, the direction of COVID-19 cases can change quickly. If we have a correction when case counts are rising, then traditional defensive investments like utilities will work well, since investors tend to move towards defensive sectors and bonds during uncertain times, Paulsen says. But if a correction happens when cases are in a clear downward trend — and with nearly 55% of the U.S. population fully vaccinated and hope for a vaccine for younger children, this could be the case — investors could disfavor those traditionally defensive investments, he adds. That's because falling cases will cause investors to expect the economy will reopen, and when that's the case investors favor economically-sensitive sectors like hospitality, not defensive investments.
Investments that aren't traditionally defensive, like cyclical stocks, small-cap and international stocks, could benefit from COVID-19 cases coming down, Paulsen says.
How investors should prepare for a market correction
When investors are worried about a market downturn, they tend to seek out a safe haven in bonds and run for cover in defensive sectors, like utilities and consumer staples. But because the market is unpredictable and defensive stocks might not hold up as well usual because of the uniqueness of COVID-19, it's best to always have an all-weather portfolio.
In general, everyday investors need to set up their portfolio so that it doesn’t matter what happens on a day-to-day, week-to-week basis, says Jeff Mills, chief investment officer at Bryn Mawr Trust. You likely won’t be able to time the market, so build a portfolio that is set up for long-term survival, which means having exposure to a lot of different asset classes, rebalancing regularly and not changing your portfolio with every market move.
But if you’re nervous about an upcoming market correction, the easiest move you can make is to shift more of your portfolio to less volatile asset classes, like bonds, Campos says. For example, if your portfolio breakdown of stocks to bonds is 80/20, consider shifting that to 70/30.
If you want to lower your risk in the stock portion of your portfolio specifically, one option is to reduce your exposure to emerging markets, given the concern with the Chinese housing market and regulatory risk. Portfolio allocations are different for each investor and are shaped by the investor’s financial situation, goals and risk tolerance, but for example, if you have 15-20% of your equities in emerging markets, consider reducing that to as low as 5%, Campos says.
Investors could also consider decreasing exposure to tech stocks, which have done particularly well in recent years, he adds. Some investors have as much as 60-70% of their stock portfolio in tech and should consider bringing that down to 35-40%.
Overall, it’s best to set your portfolio up for success over time and not panic when the market does see a downturn.
“Do your best not to react when it seems like the sky is falling,” Mills says.