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Capital Market Impact

Correction concerns

February 02, 2022

daily trading range

As 2021 ended, stock investors were lulled into a sense of complacency due in large part to the market’s remarkable resiliency over the past three years. Despite unprecedented challenges, including a sharp and painful bear market in March 2020, the S&P 500® Index registered an annualized return of 25% over this time. Last year saw relatively calm and stable stock market performance; the S&P 500 returned 28% with a maximum drawdown during the year of 5%. For comparison, the benchmark stock index historically has returned around 10% on an average annualized basis. The maximum drawdown in any given year has averaged around 14%.

The first month of 2022 is a stark contrast to 2021, both in return and stability. The S&P 500 has rapidly entered correction territory with a 10% decline from its recent peak, driven simultaneously between worries about inflation and Federal Reserve rate moves and concern over earnings and economic growth. Volatility has also been notable with an average daily trading range of 2.0% for the S&P 500 (see chart above), double the average from last year. Elevated volatility is common during market drawdowns, as periods of positive returns are historically calmer than negative periods. Market declines can often produce vicious circles of investor concern, which drives emotional reactions and exacerbates declines.

For long-term investors, patience can help navigate these periods, avoiding the emotional decisions that may impact returns and impede progress toward their investment goals. For investors who have been looking for an entry point into the stock market or have cash on the sidelines waiting to be put to work, corrections often offer opportunities to invest at lower prices, creating a potential for outsized gains on the rebound. In other words, buy low and sell high. It’s one way financial professionals can help clients feel like they’re “in control” of their financial plans during a volatile spell in the stock market.

For investors with more immediate goals in mind, market corrections can open the door to actions, if taken with consideration to their overall financial plan. For example, retired clients who are taking systematic monthly withdrawals from IRAs and 401(k)s to meet annual RMD amounts may want to consider pausing distributions for the time being. Taking withdrawals in a down market means selling more shares at reduced values to meet monthly distribution requirements. The annual RMD amount will remain the same, but it may be more advantageous to meet these withdrawal requirements after values rebound.

A downturn may also be a good time for investors to lock in investment losses in taxable accounts. The tax rules allow filers to deduct up to $3,000 in investment losses per tax year that can be booked against ordinary income. At year-end, investors can use those losses to offset realized investment gains, essentially creating tax-free income. The proceeds from the sale of investment losses can then be reinvested, but it’s important not to get too aggressive with this approach. Investors could get caught by the “wash sale” rule, which disallows the deduction of losses if the sale proceeds are reinvested in a “substantially identical” security within 30 days.

Finally, investors who have been considering a Roth IRA conversion can use a market downturn to maximize the opportunity. Let’s say a client has several funds held in traditional IRA that collectively is down 20%. A few of these funds are down even more, 30% or 35% for example. If there’s a reasonable expectation that these funds will rebound in value, the investor can transfer them to a new IRA without selling them. (Check first with the IRA custodian to see if this move is allowed.) Once the transfer is complete, the investor can convert the new IRA to a Roth to optimize the tax-free growth potential.

We’ve compiled these downturn strategies to help financial professionals identify opportunities to help clients during periods of market downturns. You can find more information about tax-efficient retirement income here. Financial professionals and clients should consult with a tax professional before making any investment decisions with tax implications. Collaborating with a team of financial professionals can help investors navigate any period of market downturns with greater confidence.

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