Are Market Corrections Risk Or Opportunity?

It’s axiomatic that past market corrections are viewed as opportunities, but current and future corrections are viewed as risk. For most of the year, investors had been saying a pullback was inevitable, healthy, and should be welcomed. When the correction finally happened in September and October, the S&P 500 dropped about 10%. And, not surprisingly, everyone freaked out. The financial media used words like “carnage” and “slaughter”. I started hearing about selling to protect portfolios. Of course, you want to sell before the correction and buy during it (as I did for my clients), but human psychology can make that hard to put into practice.

This past correction was the 90th 10% correction the market has experienced since 1928. That’s about once every 11 months, on average. It’s been three years since the last 10% correction. So, we were certainly due. One might think that something so expected and normal wouldn’t shock the investing public, but it did.

Napoleon defined a military genius as: “The man who can do the average thing when all those around him are going crazy.” It’s the same in investing. A value investor doesn’t look to make genius trades, he just has to not go crazy when everyone else is, like they were in October. If you see good value, take advantage.

I’ve written about this before, but it bears repeating. Stock plunges are why stocks return more than other assets. Imagine, if stocks weren’t volatile and they went up 8% a year, every year, with no volatility, what would happen to the investing world? Nobody would own bonds or cash. Why would you if you could earn a steady, stable 8% return in stocks? Of course, the paradox is that if stocks never crashed, prices would rise so high that a new crash would be guaranteed. That’s why the whole history of the stock market is boom to bust and back again. Volatility is the price you have to be willing to pay to earn higher returns than other assets. That’s why I always say that stocks are not a good short-term investment, but they are the very best long-term investment. If you can look past the volatility, you have a low-risk-high-return asset.

It’s easy to watch the market fall rapidly and think, “Everyone is selling. They must know something I do not.” Of course, that isn’t so. The herd mentality in short-term market movement isn’t at all rational. The markets are akin to a natural system with ebbs and flows. The value investor focuses on the prices being offered, not what changing prices might foretell. Stock corrections are not good predictors of underlying economic weakness or strength. There have been dozens of corrections greater than 10% over the past century that were not followed by a recession. There is a huge disconnect between stocks and the economy. The correlation between GDP growth and subsequent five-year market returns is -0.06, which means there is basically no correlation at all.

It looks like this last market correction has run its course and I am happy we were able to use it to add some value to portfolios. Going forward, there will be many more such corrections, some much more significant than a 10% drop. I’ll do my best to take advantage of those too. The key is to stay calm when prices fall and see what value can be found there.

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