Are You Prepared for the Inevitable Market Correction?

in Investing by

I write this at 6:00am as I sit on a patio overlooking the hills of northern Scottsdale, Arizona. The sun is rising in the east, illuminating the thousands of saguaro cactuses spread out across the desert floor. Apparently the Sonoran Desert is the only place on earth these cactuses grow native, and they can reach over 70 feet tall (although I’ve never seen one this big). That’s just one of many interesting facts I’ve learned while here.

My folks spend a few weeks a year in Scottsdale, and I can’t blame them. It’s absolutely beautiful. It offers them a nice escape from the dreary grayness that characterizes so much of the year in Seattle. I’m just down here visiting. I wasn’t planning to write while on vacation, but inspiration can strike anywhere, and at any time. One day during our morning routine (i.e. wake up, make coffee, read the news), my dad asked about a headline he came across and narrated it aloud: “investors are getting out of US stocks”. I took one look at the article and knew immediately I found my next topic.

The story describes how investors are piling into bonds out of fear of an upcoming market correction. It is very much in line with other articles in the press. It seems the vast majority of investors believe a market correction is not just possible, but inevitable. And this probably wouldn’t be an issue, except many articles advise readers to take action.

So are we really due for a correction? And if so, should you do anything to prepare?

What is a Market Correction?

Let’s first define a correction, as the media is usually pretty vague. The most widely accepted definition is a drop of 10% or more in the stock market. But this is merely one characteristic, and a quantitative one at that. Corrections take many forms, but are generally unexpected, sudden, and triggered by a singular story in the media. The story could be market related, or even geopolitical. It almost doesn’t matter. The key is it drives a fear-based selloff.

So why would a mostly inconsequential media story cause investors to panic and sell? It’s primarily due to the run up. There will be times when equity valuations become overstretched. Said another way, prices can grow too quickly relatively to the amount of underlying growth, whether in corporate profits, the general economy, or elsewhere. As this occurs, investors become increasingly tense. They realize their good fortune and don’t want to give up any hard earned gains. As such, it only takes a small amount of fear and they start jumping ship.

This isn’t necessarily a bad thing. As the name would imply, the market “corrects” itself to a more fundamentally sound trajectory. This is healthy since frothier segments are cut back to size. It usually happens over a few weeks, but it could also occur over a few months. Each one is unique, and once complete, the market reestablishes its upward march. This is in stark contrast to a bear market, which is characterized by a fall of 20% or more, usually coinciding with a prolonged economic downturn.

Bull Market Corrections Chart

Is a Correction Inevitable?

Inevitable? No. But it’s certainly possible. Let’s just say we wouldn’t be surprised to see one occur in the next twelve months. This bull market has had a nice run, and gone more or less unchecked for a couple of years now. This can lead to various pockets of excess, as we saw with social media technology, biotech, or even small cap stocks—the so called “momentum” plays. But all of these segments pulled back in recent months. The forward PE of the Russell 2000, for instance, now sits at ~18.5x, which is back below historical levels. And the S&P 500 is trading at around 16x forward earnings, which is approximately in line with its historical average.

So the market in aggregate does not look tremendously overvalued. Clearly it’s hard to imagine stocks rising when all you see are negative headlines in the news. But markets climb a wall of worry. We would be more concerned if the media was overly positive.

Should You Prepare?

We strongly advise against trying to time a correction, or even avoid it altogether. An oddly fitting analogy came to mind as I watched wildlife here in the desert. Two animals made appearances less than fifty feet from our back patio: a road runner (yes, they actually exist and are pretty hilarious to watch run) and a coyote. And trust me, I tried. But despite a week of observation and a camera phone on constant standby, I failed to capture a shot of one chasing the other. Regardless, we all know the classic Looney Tunes story: Wile E. Coyote sets one trap after another as he attempts to capture the lightning fast (and mostly oblivious) road runner. But no matter how elaborate, smart, or complex his trap, it always backfires. He ends up getting crushed by a large rock, or is sent flying off a cliff by a defective catapult or Acme rocket gone wild.

Attempting to time corrections is just as dangerous. They are simply too fast and unpredictable. You have no way of knowing when they will occur, making it darn near impossible to sell stocks at exactly the right moment. Take last year for example. At the time, many said a correction was overdue, just as today. But if you ditched stocks in favor of cash or bonds, you would have missed the S&P 500’s +32% return. That’s a big miss! Why risk it? Even if you time the downturn perfectly, you still need to know when to jump back in. This might seem easy, but most investors sit in cash far too long than they should.

The best thing you can do is have a properly diversified investment portfolio. This will help mitigate temporary asset class swings. And within equities, more equally weighting size, style, and sectors creates an additional layer of diversification. We call this Smart Indexing, and it can help ensure you aren’t overly exposed to “momentum” categories. Over time this can reduce volatility and improve portfolio returns.

There’s a reason they call the market the Great Humiliator—it has a way of putting even the most seasoned investors in their place. It is a lesson the coyote should have learned long ago.

Photo: Wikimedia Commons

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Brendan Erne, CFA
Brendan Erne serves as the Portfolio Management Team Leader with Personal Capital Advisors. He has over 15 years of industry experience, spanning almost all levels of the investment process, including several years at Fisher Investments as an equity analyst covering the Technology and Telecommunications sectors. He also co-managed a large cap growth portfolio and co-authored Fisher Investments on Technology, published by John Wiley & Sons. Brendan is a CFA charterholder.

12 comments

  1. Financial Samurai

    The tech/social media space already has had a severe 20%+ correction with LinkedIn, Twitter, FB, Netflix, Tesla all getting crushed. But it’s nice to see them come back a little.

    I’m impressed with how strong the month of May was. There is no more fear in the market it seems. Even sleepy Apple is over $600 a share now.

    Personally, I’m diversifying into real estate. I love trading Vaporware stocks for something tangible and that provides utility.

    Reply
  2. BARBARA FRIEDBERG

    Brendan, I’ve been thinking about writing this same article. I particularly resonate with this,
    “The best thing you can do is have a properly diversified investment portfolio. This will help mitigate temporary asset class swings. And within equities, more equally weighting size, style, and sectors creates an additional layer of diversification”. As a 3 decade investor, the only market timing I do is add to my positions after a decline. So far, so good.

    Reply
  3. Ron Wilson

    Excellent article with just the proper dose of humor.

    Reply
  4. Chris Thomas

    Wonderful article, Brendan. This subject has been on my mind. I keep thinking… isn’t there some algorithm that can help with market timing? Sounds like there isn’t. I guess the closest thing would be to do as Barbara suggests in her comment: increase your positions when you have a vague sense that somewhere near a bottom. I suppose though, that’s still trying to time the market, so I imagine you wouldn’t recommend that.

    Reply
  5. Rob

    two thoughts, if your like me and own quality dividend paying stocls a correction represents a buying opportunity. Last year when all the fewrs over QE were running rampant I used the opportunity to stock up on a bunch of REITS, they were down some 20%

    Secondly if you own ETFs or MF than a market correction is a chance to rebalance back into what ever your ratio is.

    One shouldn’t fear market corrections

    Note I own only CDN stocks

    Reply
    • Chris Forsyth

      Maybe this is a dumb question, but if a correction represents a buying opportunity, where does the money come from to do the buying? I guess I could keep a certain amount of cash just lying around earning nothing (negative after inflation) but most advisors seem to discourage this. Am I missing something?

      Reply
      • Financial Samurai

        There’s plenty of cash sitting on the sidelines.

        Reply
  6. Ruk

    Diversification only works if the assets you use to diversify have a high level of non correlation.

    Unfortunately , when markets really sell off the level of correlation goes up significantly
    especially in index funds, upwards of 90+ %

    Reply
  7. Zachary David Hoffman

    What you can also do is find stocks with low valuations and strong fundamentals. The example that comes to mind are oil stocks and utilities.

    Also, one note. 15x is normal for a TTM P/E, but high for a forward P/E. Also, be careful using forward P/Es, as the earnings part of that equation is just an estimate that analysts make.

    Reply
  8. rimbaud

    For those happy that their IRAs 401-Ks have recovered, It’s important to know that they are still at some risk and to learn to “capture their gains” or “take their profits”.

    Stock market traders discuss the fundamental good and bad news about companies as if they intend to be long-term equity shareholders of those companies. But those discussions are only intended to gauge (or to manipulate) the mood of traders (to establish the gambling “odds”). Their profits come not from the successes of those companies but from their own successes in “trading” (not from the profitable actions of the companies but from their own “profit taking” in positive trades). Are there even retirement funds, anymore, that hold on to an equity investment for decades. How many investors still rely on dividends as their profits for owning stocks?
    Gamblers are interested in the health and performance of the horses, but only for the bet.

    Reply
  9. Mitch

    This premise is flawed: “Corrections are generally unexpected, sudden, and triggered by a singular story in the media. The story could be market related, or even geopolitical. It almost doesn’t matter. The key is it drives a fear-based selloff.”

    Anybody can pick a random event in a chaotic system, and in hindsight assign an arbitrary news headline as the cause. A correction is a construct analogous to the number of days it rained last year. If it has no predictive power, then it’s just seeing patterns in your tea.

    If you’re trying to advise non-investors on a mass scale, why not just tell them, “The stock market is, to a first approximation, a random walk around trends measured in decades. Pick a couple of low-fee index funds in proportion to your risk tolerance, and don’t read the news.”

    It’s not as exciting as a narrative, but it’s more honest. Or just post a link to the Wikipedia page on technical analysis, and call it a day. The section that discusses the lack of studies showing anything more than marginal efficacy is a good choice.

    Reply
  10. Blaine Gregory

    I have been compiling some things for my investing course I offer at the local community college. Looking for examples of how people “in the know” often begin to look for problems with the stock markets well before the event takes place. This is not only a great article but this chart is one that will be very helpful in visually showing what is taking place during a bull market. I have used several tools from Marketwatch, Motley Fool, and even this neat stock market correction tool which tracks the data on a daily basis against the most recent corrections in the S&P 500. I can’t believe how much has changed in education since I was teaching classes at the learning annex 20 years ago!

    Reply

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