Last week, the S&P 500 hit correction territory, which is defined as a 10% decline from a previous high. Stocks rebounded on Friday, so the S&P 500 sits a little over 8% below its mid-February high, including the more than 2% decline last week. The Magnificent 7, consisting of Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), Apple (AAPL), NVIDIA (NVDA), Alphabet (GOOGL), and Tesla (TSLA), has faired worse with a drubbing of almost 18% since mid-December. The pressure on stocks seems to come from an economic growth scare, which includes plunging consumer confidence, with additional fuel provided by the policy uncertainty surrounding tariffs.
Consumer Confidence
While some hard data has shown some cracks, the weaker economic data seems to come primarily from soft data, like consumer confidence data. Last Friday, the University of Michigan’s consumer sentiment index fell to its lowest reading since November 2022. Survey data can be unreliable, though, as consumers often do differently than they say. For example, in 2022, the reading fell well below current levels without triggering a recession.
Looking at past periods of depressed consumer sentiment, buying the S&P 500 every time the index fell below 65 led to an average of an 8.4% return over the next 12 months. If you miraculously could forecast the low in consumer sentiment for each cycle, the robust return was an average of 19%, with no losses for a holding period of 12 months. Using 2022 as an example, the consumer sentiment index fell below 65 in February, but buying then would have been too early since the S&P 500 lost another 9.2% in the 12 months following. However, the economy did not fall into contraction, and consumer sentiment hit its low in June, with the S&P 500 posting a 17.6% gain over the next 12 months.
Notably, political affiliation seems to be significantly impacting the consumer sentiment index. Democratic consumer confidence has plunged since President Trump’s election. This trend is not abnormal because consumer confidence among Republicans was even worse during some of President Biden’s term. Last Friday’s results did show a decline in Republican sentiment, so this could become similar to 2022.
Policy Uncertainty: Tariffs
President Trump’s use of tariffs has added to the uncertainty surrounding policy. Without knowing the size, duration, and cost to alternatively source the impacted imported product, it is impossible to estimate the impact of any future tariffs accurately. Furthermore, possible retaliation and the second-order effects must be considered.
Generally speaking, tariffs should be a headwind to economic growth as higher prices have a tax-like impact on consumer spending. They are likely to boost inflation readings on the margin, though all the increased costs might not be passed on to consumers, and strength in the U.S. dollar could provide further offsets. Lastly, the administration can withdraw or focus the tariffs more narrowly if the costs elevate recession risks sufficiently. All other things equal, uncertainty lowers the valuation investors are willing to pay for risk assets such as stocks.
While the outcome is unclear, the Baker, Bloom, and Davis composite index of economic policy uncertainty measures policy uncertainty by examining the frequency of media references to it. Given the tariff and DOGE headlines, it is probably not surprising that their U.S. policy uncertainty index is elevated.
According to an analysis by Strategas, stocks tend to do quite well following periods of policy uncertainty. For example, policy uncertainty at current levels has, on average, been followed by over 20% returns from the S&P 500 in the 12 months after. This is entirely consistent with the consumer sentiment data discussed previously, which shows that poor data typically weighs on stocks as readings worsen. Still, the pressure is released once past the point of maximum pessimism.
With the S&P 500 closing over 10% below its February 19 high last Thursday, stocks officially entered a correction. This leaves investors asking whether it will get worse before it gets better. History can help gauge the risks.
Looking at twenty-one U.S. stock market corrections since 1980, the average return in the 12 months following was 13.4%, which on the surface would lead to significant optimism from this point. If the data is sorted between periods when the U.S. economy entered recession within those 12 months after the correction, the results are less compelling at a 1.9% average gain. Of course, if an economic downturn is avoided, the results have been spectacular on average at 19.1%.
Looking at the data through the lens of batting average, stocks have been higher in the 12 months following a correction 81% of the time. If there was no recession, the success rate rose to 93% of the occurrences. As one might expect, a recession around the time of the correction causes worse outcomes, with a positive result only 57% of the time.
It can also be helpful to look at the range of outcomes when assessing the risks after a correction. Remember that this data includes two brutal bear markets, 2000 and 2007. The tech bubble burst in 2000, sending the S&P 500 down by almost 50%. Not to be outdone, the 2007 global financial crisis saw stock prices decline by over 56%.
Not surprisingly, the worst outcome in the 12 months following a correction was in the 2007 bear market, in which the S&P 500 fell another 34.8% after the initial correction and featured a recession beginning in December 2007. The best outcome was relatively recent in 2023. It followed a 2023 correction, which came on the heels of a growth scare and bear market in 2022, so when the recession was avoided and earnings rebounded, stock soared.
What To Watch This Week
Since some of this market weakness stems from economic fears, Monday’s February retail sales will be an important barometer. Consumer spending is crucial to U.S. economic growth, and January retail sales fell month-over-month.
As noted, most of the weaker economic data has been of the soft variety, like consumer sentiment. Two months of tepid retail sales in a row would raise concerns about the durability of the consumer. Retail sales are inexorably linked with employment since income generally drives the ability to spend. Cracks are beginning to show in the employment picture, so there are downside risks, but retail sales should see some increase month-over-month for February.
Fed Rate Cuts Coming: Just Not Yet
As the growth scare unfolded and policy uncertainty increased, markets have begun to expect more Federal Reserve (Fed) rate cuts in 2025. In early January, expectations for Fed cuts fell to only one for the year but have increased to between two and three cuts, with the first cut expected in mid-June.
The Federal Reserve meets on Wednesday, and while no changes to monetary policy are expected, Chair Powell’s statements will be closely followed. Markets will be keen to judge the timing of the next cut and the committee’s views on inflation and the health of the U.S. economy.
Conclusions
There are no sure things when it comes to forecasting the short-term movement of stocks. For example, one thing we can learn from the past is that dreadful consumer confidence, high policy uncertainty, and stock market corrections don’t automatically spell doom for the future of stock returns. Long-term, stocks have been the best-performing investment, with an annualized return of 9.9%. The price for this ability to outrun inflation by a sizable margin and compound wealth has been periods of painful and unforeseeable declines.
Recent stock declines reinforce the timeless advice to keep enough safe assets to fund short-term expenses. While stocks compound wealth over long periods, they are subject to the whims of sentiment and animal spirits, making them unreliable for short-term liability needs. Unlike in recent years with ultra-low bond yields, high-quality bonds have returned to their historical function of providing income and a safe haven as stocks and other risk assets have declined. Holding a portfolio with enough cash and bonds to cover short-term expenses can help cushion the impact of any stock declines on a portfolio and allow one to ride out stock declines to experience the benefits of long-term ownership.