Don’t live in fear of a market correction. Make it work for you

How to play the volatility

(Spencer Platt/Getty)

(Spencer Platt/Getty)

Investors got a rude awakening in January when the S&P 500 fell 7%, after climbing 31.8% in 2013. Although stocks have recovered since then, there was good reason to be worried: history shows that the market is overdue for a correction of at least 10%.

Since 1946, the stretches when world’s most watched index grows (e.g., between corrections and bear markets) have averaged 18 months. It has now been 28 months since the S&P 500 fell by 10% or more. It’s taken two years or more for a correction to occur just six other times since the Second World War, says Sam Stovall, chief investment strategist with S&P Capital IQ. That doesn’t mean for sure there will be a correction in 2014, but investors should brace themselves for more volatility. “Corrections may be delayed, but they are never repealed,” he says.volatility-side

What we saw in January was what Stovall calls a pullback. These declines of between 5% and 10% happen most years. There are several reasons for the recent volatility, says E. B. Tucker, an analyst at Baltimore’s Stansberry & Associates Investment Research, but the main culprit is the Federal Reserve’s quantitative easing program. In December the Fed began reducing its bond-buying purchases from US$85 billion a month. While the Fed has said that it won’t stop the asset purchases if the economy doesn’t improve further, investors are still jittery. “The question is what happens if it stops,” he says. “That’s the main variable that’s driving the market.”

More significant corrections tend to come out of the blue, says Stovall. A sudden interest rate hike, faster inflation or an outbreak of war in the Ukraine, for instance, could be catalysts for 10%-plus drop.

While most experts advise against trying to time the market, Tucker and Stovall say now is a good time to take some capital gains, hold more cash and wait for the market to dip. The S&P 500 has risen by 7.8% on average in the periods between pullbacks, which run about three months. You’ll likely have to wait longer for a true correction, but the rebound will be higher.

No one’s predicting another great recession, but after a strong 2013 investors must buckle up. “The longer we go without a correction,” says Stovall, “the greater the likelihood there will be one.”