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7 things to remember about a plunging stock market

The Motley Fool logo The Motley Fool 12/6/2018 Sean Williams

Batten down the hatches, because we're in the midst of another market sell-off.

On Tuesday, the iconic Dow Jones Industrial Average dipped nearly 800 points. Meanwhile, the broader-based S&P 500 and tech-heavy Nasdaq Composite shed 90 points and 283 points, respectively. In terms of nominal declines, it was one of the steadier red days of 2018. Shares were falling even more Thursday.

Here's why the stock market is plummeting

Why the investing train wreck, you ask? Part of the answer could be the inversion witnessed on Monday between the three-year Treasury yield and the five-year Treasury yield. Normally, we would like to see short-term bonds paying a lower interest rate than long-term bonds. But when this yield curve flattens or inverts (i.e., the gap between short-term and long-term rates shrinks or goes negative), it can discourage lending. That's because banks make their money by borrowing at short-term rates and lending at long-term rates. Every recession since the end of World War II has been preceded by a yield curve inversion, so it clearly has the market on edge.

Another issue is that the market is always forward looking, and frankly, it's tough to see how things can get any better than they are now. Corporations and taxpayers have almost fully realized the impact of tax cuts tied to the passage of the Tax Cuts and Jobs Act, and historically, we've not seen the unemployment rate stay below 4% for an extended period of time. This suggests that growth will likely slow in 2019, with the unemployment rate destined to rise.

Related video: Investor concerns about slowing growth drive stocks lower (provided by Bloomberg)

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There's also no surefire solution to the trade war between China and the United States or to Britain's exit from the European Union. A 90-day tariff cease-fire is a Band-Aid that Wall Street cheered earlier this week, but it's no guarantee that China and the U.S. can come to a new trade agreement that's amicable to President's Trump and Xi. As for the U.K., a so-called hard Brexit could push its economy into a recession, which would be bad news given its importance to global trade.

In other words, there are plenty of reasons for investors to be worried right now.

Then again, there are also reasons for long-term investors to be genuinely excited about this decline in the market, as it gives them an opportunity to buy into businesses they believe in at a reduced cost. Before you consider heading for the exit, here are seven things you'll want to keep in mind.

1. Corrections occur more often than you realize

To start with, you should understand that stock market corrections are actually a normal occurrence. According to data from market analytics firm Yardeni Research, there have been 37 corrections -- i.e., a decline of at least 10% from a recent high -- in the S&P 500 since 1950. That's one about every 1.8 years.

Now, understand that this doesn't mean stock market corrections adhere to the averages. We could go years without one, or, as we've witnessed in 2018, we could have two corrections in less than 10 months. The point is that we shouldn't be caught off guard by stock market corrections.

2. They generally don't last very long

Another thing to realize about stock market corrections is that they usually aren't long-term events. Not counting our current correction, 22 of the previous 36 corrections in the S&P 500 found their bottom in 104 or fewer days, with just two corrections lasting longer than 288 days since 1982. Since 1950, the stock market has spent close to three-quarters of all calendar days in expansion mode, which certainly favors bullish investors.

3. Emotional investors overshoot in both directions on short-term events

A plummeting stock market almost always involves emotional trading. Even if you have a sound head on your shoulders, there are more than enough short-term traders out there capable of whipsawing the stock market lower (and higher). You should know that investors have a long history of overshooting to both the upside and downside based on short-term news events. Rarely, though, do these short-term events have any long-term bearing on the outlooks of publicly traded companies.

4. The market's best days often occur near its worst days

You might also be surprised to find out that the stock market's best trading days typically occur within two weeks of its worst days. This suggests that if you head to the sidelines in order to avoid some of the market's biggest down days, you'll also miss out on some of its big gains. According to an analysis from J.P. Morgan Asset Management, missing just the 10 best trading days in the S&P 500 over the 20-year period between Jan. 3, 1995, and Dec. 31, 2014, would have slashed your aggregate return to 191% from 555%.

5. In real terms, this decline isn't a big deal

Investors should also be aware that Tuesday's stock market "plunge" was only a plunge in nominal terms. While I agree wholeheartedly that we're not used to seeing the Dow fall around 800 points or the Nasdaq shed close to 285 points, these declines weren't all that impressive or worrisome on a percentage basis. The Dow and S&P 500 would need to plunge by roughly 7% in order to qualify for a top-20-percentage decline of all time. In other words, focus on percentages rather than points -- it'll help calm your nerves.

6. Corporate fundamentals probably haven't changed

Extreme stock market volatility is never fun, but it's important to realize that it has virtually no bearing on the underlying fundamentals and long-term strategies of publicly traded companies. A 283-point drop in the Nasdaq Composite may be unwelcome, but it's not going to change Amazon.com's focus on the cloud, halt Facebook's desire to improve average revenue per user in international markets, or slow Netflix's international streaming expansion efforts. There's a good chance this correction hasn't changed one thing about your initial investment thesis in the stocks you own.

7. Long-term investors are batting 1.000

Finally -- and this may be the most important point of all -- long-term investors have a perfect track record of success. Sure, the stock market may undergo a correction every 1.8 years, on average, but the variable of time has proven long-term optimists successful each and every time. Every one of the S&P 500's 36 corrections has been erased by a bull-market rally, and that'll almost certainly be the case with the current correction. Buy high-quality stocks, stay the course, and reap the fruits of your patience over the long run.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Facebook, and Netflix. 

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