The Reality of Stock Market Corrections and What to Consider
InvestorEducation / Learning to Invest Jan 09, 2008 - 09:58 AMBy: Steve_Selengut
Every correction is the same, a normal downturn in one or more of the Markets where we invest. There has never been a correction that has not proven to be an investment opportunity. You can be confident that the Federal Reserve, as hypnotized as it is with keeping inflation under control, is not going to cause either a financial panic or a prolonged recession with tight money and high interest rate policies. While everything is down in price, as it is now, there is little to worry about. When the going gets tough, the tough go shopping.
Every correction is different, the result of various economic and/or political circumstances that create the need for adjustments in the financial markets. In this case, the overheated real estate market took a breather; an overdose of bad judgment among lending institutions produced a major hangover; and a damn the torpedoes Stock Market, propelled by demand for speculative derivative securities (ETFs), and Hedge Funds is finally falling back to more earthly levels.
The reality of corrections is one of the few certainties of the financial world, a reality that separates the men from the boys, if you will. If you fixate on your portfolio Market Value during a correction, you will just give yourself a headache, or worse. None of the fundamental qualities that made your securities "Investment Grade" just six months ago---when your Market Value was at an All Time High---have changed. Very few (if any) interest payments or dividends have been cut. Only the prices have changed, to preserve the reality of things---and in both of our markets. Welcome to the Big Buy Low!
Corrections are beautiful things, but having two of them going on at the same time is like a trip to Fantasy Land. Theoretically, even technically I'm told, corrections adjust prices to their actual value or "support levels". In reality, it's much easier than that. Prices go down because of speculator reactions to expectations of news, speculator reactions to actual news, and investor profit taking. The two former "becauses" are more potent than ever before because there is more self-directed money out there than ever before. And therein lies the core of correctional beauty! Mutual Fund unit holders rarely take profits but often take losses. Additionally, the new breed of Index Fund Speculators is ready for a reality smack up alongside the head. Thus, new investment opportunities are abundant!
Here's a list of ten things to think about or to do during corrections:
1. First of all, don't beat yourself up by looking at your account Market Value. You don't live in a vacuum and you are not immune to market price variations. That is why you should only buy the highest quality securities in the first place and stick with a well-defined Asset Allocation plan. Look for ways to add to your portfolios---that's what the smart guys are doing.
2. Take a look at the past. There has never been a correction that has not proven to be a buying opportunity, in spite of the media hype that this one is somehow special. When they are broad, fast, and deep, the rally that follows is normally broad, fast and steep. Get ready to party... soon!?
3. The Smart Cash that was accumulating during the last rally, the one that ended abruptly in May, should be mostly back to work… too soon is normal. There are no crystal balls, and no place for hindsight in an investment strategy. Buying too soon, in the right portfolio percentage, is nearly as important to long-term investment success as selling too soon is during rallies.
4. Take a look at the future. Nope, you can't tell when the rally will come or how long it will last. If you are buying quality securities now (as you certainly should be) you will be able to love the rally even more than you did the last time---as you take yet another round of profits. Smiles broaden with each new realized gain, especially when most Wall Streeters are still just scratchin' their heads.
5. As (or if) the correction continues, buy more slowly as opposed to more quickly, and establish new positions incompletely so that you can add to them safely later. Hope for a short and steep decline, but prepare for a long one. There's more to "Shop at The Gap" than meets the eye, and you may run out of cash well before the new rally begins. Cash flow is king, so take smaller profits sooner than usual as long as there are abundant buying opportunities. Today, nearly sixty percent of all Investment Grade Value Stocks are down more than 15% from their 52-week highs.
6. Your understanding and use of the Smart Cash concept proves the wisdom of The Investor's Creed. You should be out of cash while the market is still correcting---it gets less scary each time. As long your cash flow continues unabated, the change in market value is merely a perceptual issue.
7. Note that your Working Capital is still growing, in spite of falling prices, and examine your holdings for opportunities to average down on cost per share or to increase your yield on fixed income securities. Examine both fundamentals and price, lean hard on your experience, and don't force the issue.
8. Identify new buying opportunities using a consistent set of rules, rally or correction. That way you will always know which of the two you are dealing with in spite of what the Wall Street propaganda mill spits out. Focus on Investment Grade Value Stocks; it's just easier, as well as being less risky, and better for your peace of mind.
9. Examine your portfolio's performance: with your asset allocation and investment objectives clearly in focus; in terms of market and interest rate cycles as opposed to calendar Quarters (never do that) and Years; and only with the use of the Working Capital Model, because it allows for your personal asset allocation. The only index number to use for comparison purposes with a properly designed value portfolio is the brand new IGVSI.
10. So long as everything is down, there is nothing to worry about. Downgraded (or simply lazy) portfolio holdings should not be discarded during general or group specific weakness. Unless of course, you don't have the courage to get rid of them during rallies---also general or sector spefical (sic).
Corrections (of all types) will vary in depth and duration, and both characteristics are clearly visible only in institutional-grade rear view mirrors. The short and deep ones are most lovable; the long and slow ones are more difficult to deal with. Most recent corrections have been short (August and September, '05; April though June, '06) and difficult to take advantage of with Mutual Funds. So if you over-think the environment or over-cook the research, you'll miss the party. Unlike many things in life, Stock Market realities need to be dealt with quickly, decisively, and with zero hindsight. Because amid all of the uncertainty, there is one indisputable fact that reads equally well in either market direction: there has never been a correction-rally that has not succumbed to the next rally-correction.
If you were head scratching on Smart Cash, Working Capital, or The Investor's Creed, hit your search button.
By Steve Selengut
800-245-0494
http://www.sancoservices.com
http://www.investmentmanagemen tbooks.com
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"
Disclaimer : Anything presented here is simply the opinion of Steve Selengut and should not be construed as anything else. One of the fascinating things about investing is that there are so many differing approaches, theories, and strategies. We encourage you to do your homework.
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