Why a 5% pullback can feel like a crisis

By Will Hubbard

I was talking with someone recently about the economy and the markets, and they said, “March was a bad month.”

I understood what they meant. The market was down, headlines were negative, and portfolios were lower than they had been not long before. But the comment also stuck with me, because it says something important about how many investors now experience even normal market volatility.

That reaction is understandable. We’ve had a long stretch in which weakness has often been brief and rebounds have come quickly. In that kind of environment, even a modest decline can start to feel like something bigger is happening.

This year is a good example. The S&P 500 hit all-time highs near the end of January. By the end of March, it was down about 5% and roughly 7.5% off those highs.

To me, the bigger issue is not the pullback itself. It is that a normal pullback is now often interpreted as something abnormal. And that can create a lot of unnecessary anxiety for investors.

Pullbacks are common

History suggests these pullbacks are not unusual. Since 1980, the S&P 500 has declined by 5% or more in 93% of calendar years and by 10% or more in 48% of calendar years. Over that same span, the market’s average intrayear decline has been about 14%, while the average calendar-year return has been about 13.3%.

In other words, volatility is not an exception to long-term investing. It is part of the experience.

That’s why I have a hard time describing a 5% decline, or a market that is a few percentage points off its all-time highs, as truly a “bad” month.

Uncomfortable? Sure.

Pleasant? Not really.

Unusual? Not at all.

A 5% pullback is not a market malfunction. Market volatility is more like the weather: always changing, sometimes uncomfortable, but a normal part of the environment investors live in.

Elevated valuations raise the stakes

What makes the current setup more interesting to me is not the pullback itself. It’s that investors are dealing with that pullback while valuations are still elevated.

As of April 17, FactSet reported that the S&P 500’s forward 12-month price-to-earnings ratio was 20.9, above both its five-year average of 19.9 and its 10-year average of 18.9. At the same time, the cyclically adjusted price-to-earnings ratio stood at 40.44, far above most of its long-term history.

That does not mean the market has to fall tomorrow. Valuation is not a great short-term timing tool. Expensive markets can stay expensive for a long time. But valuations still matter.

They matter because they can shape expectations and influence how much disappointment the market can absorb. When starting valuations are elevated, the margin for error gets smaller.

A richly valued market doesn’t need panic to decline. It may only need some combination of slower earnings growth, sticky inflation, higher rates, or fading enthusiasm. That kind of drift is when complacency becomes the real risk.

Recent market experience can be misleading

One of the more dangerous beliefs investors can develop is that every dip will recover quickly, and therefore every dip should be bought immediately. Sometimes that works. In fact, recent market experience has probably reinforced that mindset.

But recent experience is not the same thing as long-term market history.

A 5% decline can remain a 5% decline. It can also turn into a 10% correction. Since 1980, 10% drawdowns have happened in nearly half of all calendar years. Investors should not be shocked by drawdowns. They should be prepared for them.

To me, that is the bigger message right now. Investors don’t need to panic or abandon equities, but they should take an honest look at their own personalities and behavioral tendencies to ensure they are equipped to handle drawdowns.

They should also be careful not to confuse a relatively calm recent past with the way markets always work. A mild pullback is not necessarily a signal to take drastic action. But it also should not be dismissed with the assumption that markets will immediately recover.

A disciplined process can keep investors grounded

Now is a good time to think about three things.

First, are your expectations realistic? If valuations are elevated, future returns may still be positive, but they could be harder earned and less forgiving.

Second, is your portfolio sized for your actual risk tolerance? Not the version that shows up when markets are calm, headlines are quiet, and every dip seems to recover in a matter of days. It is easy to feel aggressive when volatility is short-lived. It is much harder when the decline lasts longer or goes deeper than expected.

Third, do you have a process? A real one. A systematic one. Not a feeling or a reaction to the latest headline. Do you have a process for rebalancing, managing risk, and staying disciplined when discomfort shows up?

This is where quantitative managers like Flexible Plan Investments can complement a traditional passive portfolio. Systematic, rules-based strategies can add diversification and help investors manage risk across different market environments.

Investor complacency does not always show up as outright euphoria. Sometimes it shows up as impatience. Sometimes it shows up as surprise that markets can actually go down. And sometimes it shows up as the belief that anything short of a straight line higher counts as a terrible month.

But markets do not move in a straight line, and they never have.

A 5% pullback is not a crisis. In many years, it is barely scratching the surface of what normal looks like. So if investors are going to navigate today’s market well, especially with valuations still rich, they may need to be a little less confident that every dip will be bought and a little more respectful of the fact that volatility is still the price of admission to the equity market.