I’m generally an optimist, especially when it comes to the stock market. And if I ever feel myself getting pessimistic or negative about the market, I try and remember what my old boss, and Cabot legend, Tim Lutts used to say: “In investing, it pays to be an optimist.”
He’s right, and he has more than a century’s worth of evidence to prove it. The average annual return in the 129-year-old Dow Jones Industrial Average (which opened in May 1896) is roughly 10%, about the same as the S&P 500’s average annual return since its March 1957 founding. Stocks’ very nature is to go up, and up by a double-digit percentage every year. So, if you’re an eternal market pessimist, you’ve likely missed out on some big, and potentially life-changing, returns.
With all that in mind, I’m here to tell you that I think the market is due for a pullback. In saying so, however, I don’t think I’m violating Tim’s “be an optimist” credo. Pullbacks are normal, even healthy. Pullbacks are generally short-lived and fall short of the more nefarious “correction” designation, reserved for when the market falls by at least 10%.
I don’t think a market correction is necessarily imminent.
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We just experienced a very sharp market correction – and a brief bear market, in the case of the Nasdaq and the Russell 2000 – in early April, just over three months ago. It feels like it happened much longer ago than that. But that’s because the market has had a furious, V-shaped rally since, not only erasing all of the late-March/early-April losses but taking it to fresh all-time highs.
I believe the bull market in the S&P 500 and the Dow will remain in place through the rest of 2025, and perhaps much longer. But I think a 5% market pullback is coming, likely in the next two months. Here are three reasons why.
3 Reasons to Expect a 5% Market Pullback
1. Stocks Are Priced for Perfection.
You could say that almost any time market indices are at all-time highs. But it’s particularly true in an economic landscape dotted with such uncertainty: tariffs, whose deadline has come and gone with only a handful of deals being struck; high interest rates, with no Fed cuts since last December; two major geopolitical conflicts, in Ukraine and the Middle East, which now includes Iran; and declining, if still “fine,” U.S. GDP growth, as evidenced by the modest dip in the first quarter. True, there’s always something going on in the world that threatens to derail the global economy and, by proxy, the stock market.
But this is a LOT of “somethings.” Trading at 22.7x forward earnings estimates, the S&P 500 is nearing the highest level it’s been since mid-February … which was the previous market top until it finally eclipsed it in late June.
2. Earnings Season as Foe, not Friend.
When first-quarter earnings season arrived mid-April, it could not have come at a better time. On the heels of President Trump’s “Liberation Day” and the ensuing sell-off, the market was in desperate need of a life raft. Trump’s subsequent backpedaling in the form of 90-day pauses on tariffs jump-started the recovery.
But a very strong Q1 earnings season sustained it. Large-cap companies reported average earnings growth of 14% in the first quarter, the highest figure since 2021 and nearly double the 7% growth that was expected going in, according to data collected by FactSet.
This time around, earnings expectations are more muted at an estimated 4.8% growth. That’s because three months of tariffs and managing the possibility of higher tariffs have prompted companies and consumers alike to reel in their spending. And, with the market at record highs and no longer in need of rescuing, investors are now looking for excuses to sell rather than reasons to buy.
Look for earnings misses to get punished more than usual, and for some earnings beats to fail to move the needle much.
3. The Calendar.
September is historically the worst month for stocks by far, with an average loss of 1.2%. No other month has a loss of even two-tenths of a percent. Why is September such a bloodbath? Because after Labor Day, Wall Street returns from its collective summer vacation in the Hamptons and starts slashing losing positions that have been left to rot in the summer heat.
Last year, that led to a 4.2% decline in the S&P 500 the first week of September, though the index quickly rallied to new highs when the Fed unexpectedly slashed interest rates by 50 basis points later that month. In each of the previous three Septembers, stocks were down sharply, with the bottom coming sometime in October.
In the absence of another surprise Fed cut (or other positive surprise), I’d expect a similar downturn this September, especially if stocks continue to churn higher between now and Labor Day.
Again, I’m not trying to tell you that the sky is about to fall. Pullbacks are normal and lead to better buying opportunities on the other side. But I do think a 5% market pullback is coming between now and mid-September. When it comes, simply ride it out, sell out of some of your losing stocks, but otherwise, stay invested, because chances are, it will lead to higher prices down the road.
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