S&P Correction: Here’s What Comes Next

Contrary to what you may be inclined to believe if you conceptualize of stocks as poker chips and investing as a kind of upside down casino where the gamblers always win thanks to a benevolent pantheon of gods who perpetually stack the odds in favor of anyone willing to roll the dice, equity market corrections aren’t rare.

In fact, the S&P 500 typically suffers a drawdown of around 13% peak-to-trough in a given year. That’s the median going back to 1928, Goldman’s David Kostin noted, in his latest, on the way to reminding folks that corrections of more than 10% have occurred in 62% of all calendar years going back nearly a century.

2021 was thus anomalous — the exception, not the rule. These are, after all, exceptional times.

Typically, buying after a 10% drawdown is a good idea. Over the past 70 years, there were 33 corrections (10% or more down on the benchmark), with a median duration of five months and a peak-to-trough decline of 18%. Don’t let that latter factoid frighten you. Irrespective of whether a given correction was the trough, an investor who bought down 10% would’ve enjoyed a median return of 15% over the ensuing 12 months, with a ~76% hit rate.

As you can see from the figure (above), it doesn’t always go well, though. Sometimes a falling knife is just a falling knife.

Importantly, January’s swoon was entirely attributable to rising rates. That’s hardly a novel observation, but sometimes it’s nice to have things quantified.

“The real 10-year US Treasury yield jumped by 60bps (-1.1% to -0.5%) between the record S&P 500 high on January 3 and Wednesday’s close following the FOMC meeting,” Kostin wrote, noting that the over the same period, the S&P’s forward earnings yield rose by (basically) the same amount. “This equated to a two-year forward P/E multiple contraction of 9%, from 19x to 17x, matching the market drawdown,” Kostin went on to remark.

The familiar figure (above) is updated through Friday’s close. I’ve discussed the “gravity” exerted by real yields more times than I care to remember this month. I’ve called it “the only thing that matters.” As the quote from Kostin makes clear, you can take me literally on this point. It’s the only thing that matters for equities.

Given that, and the distinct possibility that the Fed would like to see 10-year reals in positive territory, the obvious question is this: What would happen to US equities if reals rose another ~50bps?

Goldman’s Kostin has the answer. “All else equal, the S&P 500 would decline by roughly 10% to 4,100 if the real Treasury yield rose by 60bps from -0.6% today to 0%,” he wrote.

If reals rose by 100bps, the S&P would fall to 3,800, in all likelihood triggering the Fed put.