The S&P 500 Just Hit Correction Territory. History Says the Stock Market Will Do This Next (Hint: It May Surprise You)

U.S. stocks have fallen sharply in recent weeks as the Trump administration began imposing tariffs on foreign trading partners. Investors unnerved by the potential consequences of the burgeoning trade war have rotated away from domestic equities, particularly those in the consumer discretionary and technology sectors.

As of March 13, the benchmark S&P 500 (SNPINDEX: ^GSPC) has fallen over 10% from the record high it reached in February. That means the index has officially entered stock market correction territory. But the drawdown comes with a silver lining for investors: The S&P 500 has historically rebounded quickly.

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Here are the important details.

History says the S&P 500 could rebound sharply over the next year

A stock market index enters a correction when it closes at least 10% below its most recent bull-market high. The S&P 500, commonly regarded as the best barometer for the overall U.S. stock market, has suffered nine other corrections (two of which became full-blown bear markets) in the last 15 years.

The chart below lists each day the S&P 500 entered stock market correction territory since 2010. It also shows how the index performed during the next 12 months. Importantly, the S&P 500 generated a positive return eight out of nine times, or 89% of the time.

Data source: YCharts.

As shown above, the S&P 500 in the last 15 years has returned an average of 18% during the year following its first close in correction territory. While not shown in the chart, the S&P 500 has also returned a median of 18% under the same conditions, which means it gained more than 18% half of the time and less than 18% the other half of the time.

The standard disclaimer applies: Past performance is never a guarantee of future results. Nevertheless, the data shown in the chart is encouraging and should give investors confidence. The S&P 500 has almost always generated a positive return in the year following its first close in correction territory, and that return has usually been robust.

Readers should pay particularly close attention to the correction that began in November 2018 because the circumstances were somewhat similar to the current market environment. The U.S. economy had just notched several consecutive quarters of strong growth, but escalating trade tensions with China knocked the stock market into a sharp but brief decline.

However, President Donald Trump has taken a more aggressive stance on international trade during his second term, so the current S&P 500 correction may not fit the historical pattern.

Image source: Getty Images.

The current trade war could drag the U.S. stock market down further

The Trump administration aims to "correct long-standing imbalances in international trade" by imposing tariffs across a broad range of goods from several countries. That list currently includes China, Canada, and Mexico, but the president has also threatened tariffs on imports from the European Union.

While long-term U.S. trade policy remains uncertain, the nonpartisan Tax Foundation estimates tariffs imposed to date will increase the average tax across all U.S. imports by nearly 6 percentage points, from 2.5% in 2024 to 8.4% in 2025. That would be the highest level since 1946.

Comparatively, tariffs imposed during the first Trump administration raised the average tax on U.S. imports by about 2 percentage points. That relatively small bump in the average rate contributed to the 19.8% decline in the S&P 500 observed during the three-month period between September and December 2018.

The good news is that drawdown was short-lived. The S&P 500 had recouped its losses and reached a new high by May 2019. The bad news is the current drawdown could be steeper because the Trump administration has imposed or plans to impose more aggressive tariffs this time around.

Here's the bottom line: Investors should be cautiously optimistic. Now is a good time to buy high-conviction stocks, but it makes sense to buy those stocks slowly. The current stock market correction may turn into a bear market if trade tensions keep escalating, so it makes sense to hold some cash in reserve.

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Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.