Corrections are healthy and inevitable

The recent stock market correct has resulted in a 20%+ decline in the Dow Jones Industrial Average, with the Nasdaq Composite and S&P 500 dropping by almost as much. And it’s not over. As I sit here at 3:51 a.m. Thursday morning, March 12, 2020, watching the futures market, Dow futures are down more than 1,200 points, S&P 500 futures are down 126, and Nasdaq futures are down 374. As painful as this correction may be for some market participants, it is not only healthy for the market and the economy, it is absolutely vital.

One could hope that the stock market would always advance in a consistent, orderly fashion, week in, week out, month to month, and year to year, but that is not reality. Markets are driven by investors, and investors are people – human beings that act based on emotions like greed and fear, and not cold logic. The result is that the stock market has periods of excess, followed by periods of panic. We are experience the panic part of that equation right now.

To give our discussion some context, the S&P 500 reached its all-time peak on February 19, 2020, at 3,386, which represented a 4.8% gain for the year. Yesterday’s close of 2,741 resulted in a loss of 19% from that all-time high. There are a few observations I would like to make about this recent correction. The first is, it is not over. As noted above, the futures are down pretty dramatically, so we are going to open down significantly, and the downside could certainly continue.
Second, one can clearly see a pattern of market activity that I have seen consistently over the 30+ years I have been managing money for clients – corrections happen in a hurry. The stock market can take months or even years to rally to new highs, only to be followed by a correction that can last only weeks or sometimes a matter of only a few days, with the market shedding 10%, 15%, or in some cases like the current correction, 20% or more.
Third, the math really works against investors who use a buy and hold strategy. As noted above, we are down 19% so far. To get back to that recent all-time high of 3,386, we don’t need a 19% gain, we need a 23.5% gain. This is why I always tell my clients that it is far easier to hold onto what you have than to make a profit, which is why I do not believe in buy and hold strategies.

To digress a bit, the bull market, which very well may have just ended, we have seen eleven years of strong market performance. There are many significant and interesting implications that have arisen from such an extended period of prosperity. One such implication is that the vast majority of professionals working in the financial industry have only experienced a bull market, having been in the business so to speak for ten years or less. They simply do not have the experience or perspective that comes with living and working through difficult market conditions. Also, for the first time ever, in the history of this country, a large percentage of investors are making their own investment decisions, for better or for worse. The combination of these two key factors results in confusion, uncertainty, and panic, which we are certainly seeing manifested in the volatility of late.
Returning to the current correction, I stated that corrections are healthy and vital. Because investors are human beings, they drive markets to unsustainable levels, as we just witnessed with the all-time highs that were set last month. By any valuation metric, stocks were extremely expensive. When stocks are overvalued, there is a greater risk that any little thing can cause a dramatic selloff. I will submit to you that, had the markets been grossly undervalued when the coronavirus outbreak occurred, stocks would not have sold off so dramatically, and might have even moved higher. We are not seeing these giant daily drops in the market because of the coronavirus – that is just the trigger. We are seeing these large percentage declines because stocks are overvalued.

Corrections are inevitable, whenever the stock market becomes overvalued. If we don’t have corrections periodically, eventually the market would become so overvalued that a crash will occur. We suffered through a crash in 2008 with the financial crisis. Unfortunately, sometimes crashes happen anyway, but they are much more likely when the stock market is grossly overvalued.
Corrections also offer opportunities for investors with cash available to buy stocks are more favorable prices. I raise cash when valuations become inflated, as I did earlier this year and late last year. Having cash not only offers opportunities to reinvest at attractive prices, it also cushions the downside during corrections. Cash doesn’t lose value, notwithstanding inflation and currency fluctuations. Cash gives investors flexibility. I have been using cash for my clients to buy stocks this week, especially yesterday (March 11, 2020), around the 2,750 level on the S&P 500. While the market looks like it will go lower in the near-term, I am comfortable with the prices I have paid for the stocks I have purchased for clients. My clients are in a lot better position having avoided the 20% correction we just experienced, and owning stocks purchased at much more favorable prices, with less downside risk and more upside potential, as compared with someone who has just watched their portfolio lose 20% in the past few weeks.

This brings me to my final point, which is that those investors who have employed a buy and hold strategy over the past eleven years, or some portion of that time, have likely benefited. With the strong, positive trend of the market since the 2008 Great Recession, a buy and hold strategy has worked well. However, we are not likely to experience a similar, strong, positive trend for the coming ten years. Investors are going to have to actively manage their portfolios, or they will not generate good returns.
The S&P 500 began 2020 at 3,231. As of yesterday’s close, we are down 15% from where we started the year. The S&P 500 will have to gain almost 18% just to get back to where we started 2020. This means that for most investors the prospects of achieving a positive return for 2020 are slim to none. This is certainly not the case for my clients, again because I was holding 100% cash before the correction, and just reinvested close to the current level of the market.

Given the damage the coronavirus has done to the global economy, it is difficult to imagine that the stock market is going to rally by more than 18% during the remainder of 2020. The fallout from the disruptions in worldwide business, the supply disruptions that will continue for two quarters or longer, and the negative impact on corporate earnings and the dramatic decline in consumer spending will all weigh heavily on the economy and by extension the stock market.

Active portfolio management strategies will be needed to find opportunities in the market and exploit them. Going forward, it will be a stock picker’s market. We will all have to work a lot harder to generate meaningful returns. The days of buy it and forget it are over. If we don’t go into a recession as a direct result of the impact of the coronavirus, we will have a recession within the next few years. Like corrections, recessions are healthy for the economy, and they are inevitable.

Given this recent correction in stocks, investors would be wise to reassess their investment strategy. Talk to your advisor. If you are managing your own portfolio, and you were not prepared for this correction, consider alternative approaches, or consider working with a professional who has been in the business long enough to have experienced market conditions other than the latest bull market. The landscape has fundamentally changed. We must change with it, or suffer the consequences.

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