• Investing & Markets

Are You Prepared for the Inevitable Market Correction?

June 2, 2014 | Brendan Erne, CFA

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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