​As Sam Sees It: When Buying the Next Dip, Think Lucky Number 7

Sam Stovall  |

Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.

EQ: As expected, the Fed left rates unchanged in its July meeting. That said, it did say it expects to begin unwinding its $4.5 trillion balance sheet “relatively soon.” What did you make of the comments?

Stovall: We basically felt that it was in line with expectations. There was a subtle shift in their statement in that they did say the words “relatively soon” rather than saying “sometime this year.” It implies that the Fed is certainly going to be looking at the data to make its ultimate decision as to when it will start doing the unwind. However, we don’t think it’s going to really have an impact on the market because they’re going to be very transparent as to when and by how much they do unwind the balance sheet. So, I think everybody will be finding out pretty much at the same time when and what they will be doing.

EQ: In this week’s Sector Watch, you discussed the prolonged stretch the market has had without a meaningful pullback or correction. As we discussed last week, this is particularly relevant right now as we head into the historically softer months of August and September. If and when the market gets that inevitable dip, how long have they traditionally lasted?

Stovall: We’ve gone more than 17 months without a decline of 5% or more. Normally, the average separation between bottoms of 5% or more declines and then the beginning of the next 5% or more decline has been six months. Here we are with more than 17, so it’s just a matter of time.

Since World War II, we’ve had 56 declines of 5-10%, 21 that were declines of 10-20%, and then 12 of them were declines of 20% or more (also known as bear markets). So, it really depends on the type of decline that we end up having because pullbacks have taken about one month on average to go from peak to trough. Corrections have taken about five months, and bear markets have taken more like 14 months to go from peak to trough. So, I guess it all depends on how bad things can get.

EQ: You’ve said in recent interviews that the signs of recession, and therefore a bear market, are not necessarily present at the moment. With that in mind, if we do get a dip, it will most likely be a digestion of gains in the form of a pullback or correction. Depending on what we end up getting, how long does the market typically take to get back to break-even?

Stovall: Well, here the break-even timeframe is also pretty interesting. These 56 times where we’ve had 5-10% declines, we got back to break-even in fewer than two months. On a rounding basis it equals two months, but it’s actually to the lesser side. For corrections of 10-20% declines, the average has been around four months. The interesting thing is that for 85% of all declines of 5% or more, we ended up getting back to break-even in about four months or fewer. So, really, in my opinion, you might not want to be timing the market from a perspective of when to sell, but probably more so on when to buy.

EQ: You also looked at what you dubbed The Battle of the Benchmarks, specifically the performance of the cap-weighted S&P 500 versus an S&P Equal Weight 500. What is the difference that investors need to understand between these two benchmarks? Which one performed better?

Stovall: Well, the cap-weighted S&P 500 basically looks at the underlying stocks and values them according to their market capitalization. So, you could have some companies like Apple (AAPL), which represents 5% of the entire index. In fact, what you see is that the top 50 companies represent 50% of the weighting of the S&P 500. In that case, you have a very small number of companies relative to the overall benchmark that really drives the performance of that benchmark.

With the S&P Equal Weight 500, every single company has the exact same effect on prices, earnings, etc. So, Big Lots (BIG) is the same size as Big Blue (IBM). So, with each company having the same exposure within the S&P Equal Weight 500, the characteristics tend to be closer to a mid- or smaller-cap index than the large cap S&P 500. That difference is that, instead of having just a handful of 800-pound gorillas like you do in the cap-weighted S&P 500, all stocks in the S&P Equal Weight 500 have an equal impact.

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What is most interesting, however, is the speed with which bear markets have bottomed and recovered with the S&P Equal Weight 500 as compared with the cap-weighted 500. Since Dec. 31, 1989, the S&P Equal Weight 500 required less than half the time it took the S&P 500 to fully recover from bear markets.

EQ: You also took this comparison to the small-cap level with the S&P SmallCap 600 and the Russell 2000. It seems the S&P SmallCap 600 has historically bested the Russell 2000 when the market is in recovery mode. What are some of the reasons for that?

Stovall: The S&P SmallCap 600 has 600 stocks that are very investable, whereas the Russell 2000 is basically taking the Russell 3000 and chopping off the largest 1000 stocks. The remaining 2,000 stocks, whether they are truly investable or not—meaning if they have enough float, liquidity, etc. for investors to buy and sell these shares—makes up the Russell 2000, and as a result, it becomes a bit more challenging.

So, it does appear as if the S&P SmallCap 600 has historically bested the Russell 2000 when we get into recovery mode. More specifically, we have found that while the number of pullbacks, corrections and bear markets have been pretty similar for the Russell 2000 and the SmallCap 600, as well as the amount by which they fell over a particular timeframe, it is the recovery that’s been much more impressive. It has taken only 11 months on average for the S&P SmallCap 600 to get back to break-even following bear markets, yet it took an average of 18 months for the Russell 2000 to get back to break-even.

So, like ripping a bandage off, you end up going through a painful period, but it’s over a lot more quickly.

EQ: You also noted that investors should take these dips as buying opportunities rather than a reason to bail. Looking at the market right now, where should investors be looking as they compile their potential buy list?

Stovall: Well, given that we are in bull-market mode and we don’t see a recession on the horizon, our belief is that while we could end up seeing a pullback, or maybe even a correction because we are long overdue from a time perspective, these dips should be purchased rather than avoided. Since we don’t look for a bear market, we think you probably want to maintain some exposure to the high momentum groups. Obviously, the first one that comes to mind is Technology. We also are favoring some of the more cyclical sectors, such Industrials and Materials, but also believe that there are other buying opportunities in Health Care and Consumer Discretionary.

Areas that we would be avoiding are essentially areas of weakness, such as Real Estate, Consumer Staples and also Telecom Services.

EQ: As you mentioned earlier, when the market does recover off the bottom, it doesn’t necessarily give you that much time to buy. In terms of when investors should be pulling the trigger, how should they approach taking advantage of these buying opportunities?

Stovall: It’s interesting because the average decline for the S&P 500 for a pullback has been 7%. The average decline for a correction has been 14%. The median decline for bear markets has been 28%. All of these figures are divisible by seven. There’s an old book titled, The 7% Solution. Maybe you could say that they were referring to those levels with which an investor may want to consider buying back into the S&P 500. Should the market fall by 7%, maybe you put some money to work because possibly the pullback has run its course.

If it does go on to decline by 14%, then maybe put a little more money to work. As we saw from the correction in May 2015 into February 2016 in which we bottomed at 14.2%, if an investor had put some money to work at the 14% decline threshold, they would’ve looked like a terrific market timer. So, maybe one might want to consider 7% decline thresholds, or maybe even 5% decline thresholds in which to add to their current holdings rather attempt to run.

I have found that those investors that do engage in market timing and try to get out ahead of a larger dip, sometimes they are correct and the market continues to fall a bit further. However, what usually happens is they don’t know when to get back in, and when they do finally get back in, they have traditionally purchased back in at a price that is higher than where they got out.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.

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