Anyone who follows the stock market realizes that we have just experienced a fairly significant correction. The market has recouped a fair amount of its losses, as of Friday Aug. 28, when this column is being written. I will not try to hazard a guess as to where the market will be, when this column is published.
Market corrections are typically defined as declines of at least 10%, where “bear markets” are when the market averages fall 20%. Since the end of World War II, stock market corrections have averaged about once every 20 months. Over the past 25 years they have become less frequent, as the last one we experienced was four years ago.
Given that stock market corrections have become less frequent they tend to shake up investors more now versus when they were more common. That is why this recent correction was especially worrisome for a number of investors.
The stock market in theory is a forecaster of future events. However, it is not a perfect forecaster. For example, the stock market predicts more recessions than actually wind up occurring.
In looking at this correction the risk of the economy falling into a recession does not look particularly high. Unlike the situation in 2008, the banking system is reasonably healthy. A lack of credit availability can certainly cause an economic slowdown. We have had other recessions caused by a spike in energy prices, which is certainly not the case today.
With the likelihood that the economy does not fall into a recession in the near future, that should tend to limit the magnitude of this market decline. The risks appear to be related more to a slowdown in economic activity in a number of countries, notably China. This can have an impact on corporate earnings, as international sales for U.S. companies have increased in importance over time.
Investors are always faced with one of three alternatives. They can do nothing, increase their holdings in stocks, or they can decrease their positions. When markets are calm most investors do not make major changes, though when they become volatile more moves tend to take place.
While most “experts” advise people not to panic during a market correction, selling does tend to take place. This is despite most people saying they don’t panic in a market correction. This past week nearly $30 billion was sold from stock-based mutual funds, which was a record amount. Apparently actions speak louder than words, given the magnitude of the outflows.
While panic selling is generally not a smart move, there is one situation where there is some justification for that action. That is when someone realizes they have too much exposure to stocks for their risk tolerance. This happens when individuals become overly positive during a strong market, and wind up with a portfolio that is nearly 100% in stocks. However, rather than sell everything those individuals should bring their stock positions down to a less risky level, such as 60 to 70%, and refrain from becoming overly concentrated in stock in the future.
There are some who see market corrections, as a buying opportunity. One must be careful not to become too much of a market timer. During market corrections there are oftentimes sharp moves to the upside making people think the correction is over, only to have a further drop in the future.
Buying during a market correction makes sense, if your allocation to stocks has fallen below its target range due to the correction. Investors in 401K plans should be aware of specific constraints they might have in purchasing and selling funds. Realize that in a volatile market your order may have to be in some time before the exchange closes, and the market may close at a significantly different level compared to when you placed the order.
Market corrections are certainly painful, when they are occurring, though it does give people a greater sense of the risks of investing. Also, it should remind individuals the importance of taking a longer-term approach to investing. Also, investors should realize that volatility will be higher for a period of time, and expect to see significant moves on both the upside and downside.
The key thing is not to panic. If you do make a move, it should be done in the context of positioning your target allocation of stocks consistent with your risk tolerance and long-term objectives. Finally, do not try to time the market.
