We may finally be getting the long-awaited market correction. The market has been volatile and the momentum is negative. Based on the S&P 500 we are down about 4 percent from the high, still positive year-to-date, mind you, and up considerably over any reasonable period. This leads to several questions, most importantly: Should I be worried?
Most of our clients let us do all the worrying for them – after all, that is our job – but a few always let us know when the market goes down more than a point. They call and say, “I’m watching CNBC and I am getting nervous.” It reminds me of the patient who tells the doctor, “It hurts when I do this.” The doctor’s response is usually, “Then stop doing it.” CNBC is in the entertainment business; they get paid to keep you glued to your seat. Of course they are going to make every hiccup sound like the end of the world. The most obvious example is the ubiquitous headline, “This is the lowest the market has closed since…” It is said with such fervor that you expect to hear them say “…since 1929,” but the timeframe is usually last month. I like the free ticker and find some of the commentary entertaining, but if you get stressed watching then take the doctor’s advice and stop.
Every market drop is not equal. This market has been marching upward for a long time without a breather and a correction is a healthy thing. I have been saying this for a while, but I want to make it clear why the occasional 10 percent drop (which is the official definition of a correction) in stock prices is healthy. Stock prices are driven in the long term by the underlying performance of the company whose stock one owns. I say this repeatedly and it can’t be said enough: stock is simply ownership in a company, and over time, the value of the stock will equal the actual value of the company. This is the way prudent investors see the world.
In the short run the price of the stock is determined by what people are willing to pay that day. Traders, unlike investors, see stocks as nothing more than a piece of paper people trade back and forth. Stock prices start to go up as companies do well, and investors benefit from this. Eventually, however, momentum takes over and the traders start buying. They cause the price of the stock to go beyond what the actual company is worth. At that point it becomes difficult for the investor to find anything worthwhile in which to invest. Traders keep trading upward until the market corrects, then they start to panic sell and prices go down, which is the opportunity that investors are seeking.
Let me illustrate it another way. I buy my clothes from a well-known local men’s store here in Atlanta. They are open all year long and people go in there to buy clothes all the time. Twice a year they have a big sale, and that is when I go in there to buy clothes. I get the same clothes for ten to fifteen percent less than the guys who don’t wait. A correction is a big ten percent-off sale, and when they come it is the time to buy.
Of course the fear in corrections is that they could be more than that. It could be a bear market, which is defined as a twenty percent drop in prices, or worse yet another disaster like 2008. Bear markets happen when valuations get away from reality. That has not occurred. We are still in a bull market, and there is still plenty of reason to be optimistic for the long haul. Bull markets need the occasional correction. So don’t get nervous; if anything it is almost time to get greedy.
Chuck Osborne, CFA