Corrections Are Never Pretty

Posted on Posted in Newsletters

The process of finding a bottom during a correction is always ugly: big market moves in both directions, hard-won gains wiped out in a flash, individual stocks moving 10% or more in a day (or an hour), and of course, irrational fear all around. (Fear, by the way, is always irrational.) Investors, being human, just want to get out and seek shelter until the storm passes. But this would be a mistake.

Identifying a stock market bottom is no different from finding a top: no mere mortal can do so except by sheer luck. Remember Elaine Garzarelli? I’ll bet you don’t. But she was famous in 1987 for “predicting” the October crash. Whether she actually did so is a matter of dispute, but she continued to predict the direction of the stock market with near perfect accuracy, except she was perfectly wrong. Not a single significant call that she made after 1987 was right, including her prediction at the start of the 2003 bull market that stocks would go nowhere for years (they doubled).
Getting out of stocks during times like these can be riskier than staying in because prices move so quickly. Even if you are correct and stock prices go lower after you sell, you may not be able to get back in before they move higher than when you sold. I’ve tried this many times over the past 35 years and it almost never works: prices just move too quickly and unpredictably. Yesterday, for example, the Dow rose 640 points in only 90 minutes. Expect more big moves before the markets calm down.
How do I know that we’re in a correction (a drop of -20% or so that recovers in a few weeks) rather than a bear market (a decline of significantly more than -20% that extends over months or years)? Obviously, we won’t know for sure until it’s over, but a number of items support my view:
  1. As I said in my prior newsletter, today looks a lot like 1998, including the pattern of the decline and the worries used to justify it (sovereign debt issues and an economic slowdown). The 1998 correction lasted 4 months from the time the decline began until the market recovered all of its losses. This one appears to be moving even faster.
  2. Economic data do not point to a new recession, and only 1/3 of stock market declines are followed by a recession. Thus, even with the market’s recent slide, the chances of a “double dip” are only 33%.
  3. Bear markets typically start when investor sentiment is at least moderately optimistic. When was the last time that was true? (Hint: 2007.)
  4. Corporate earnings continue to rise faster than expectations and are at all-time highs. In addition, corporations hold record levels of cash (earning almost nothing) that they will eventually need to spend.
  5. In March of 2009 I wrote an article that said stocks were as cheap as at previous major market lows. Using the same methodology, I now find that stocks just as undervalued as they were then, even if we have a recession. If there’s no recession, stocks are cheap beyond belief. (You can find the original report here: Let me know if you’d like the details of my updated analysis.
  6. Lastly, this is not 2008 in so many ways. The banks are better capitalized. Hedge funds and other big investors are far less leveraged. Corporations are better prepared to whether a slowdown. The credit markets are functioning normally. There are no bubbles waiting to burst. The list goes on.
I could give you other reasons why I continue to think this decline is just a pause in a continuing bull market that is still far from its eventual highs, but you get the idea. Remember, at times like these, emotions are your enemy, while the urge to sell is greatest just before the rebound. Don’t let fear cloud your judgment.