The last couple of weeks have been tough on equity investors. Stock markets around the world have been down big, then up big — a real roller coaster of a ride.
After going up in a straight line over the last year equity markets suddenly went into a tailspin in early February. Going through an equity correction is really scary!
First, inflation was blamed for the market volatility, then it was the “memos” (one a total vindication, the other too long to show the public), and finally it was all the old standby of sellers outnumbering buyers.
Never mind all these rationalizations of the equity market correction. Nobody knows for sure, but one thing we can all agree on is that stock market corrections are scary and leave us with a pit in our stomach.
Investors have been taught that risk and return are tied together. No risk, no return. But somehow we all love that supposedly “free lunch” when markets go up in a straight line like last year. We feel smart and invincible.
Corrections make us feel dumb, but are we really any dumber than the day before?
We should have sold those high flying stocks that Cousin Vinny recommended last year. What about those growth mutual funds in our 401K? We all experience that uncomfortable feeling that we should have known better.
These are perfectly normal feelings, but stop beating yourself up. Nobody has a crystal ball telling them when the next correction is coming!
Don’t hold yourself up to a ridiculously high standard that even the experts can’t reach.
So, what can you do when the Bear rears its scary head?
First, control your emotions. Calm yourself down — find your emotional equilibrium.
Second, analyze the type of correction you are in. Do your homework.
Third, come up with a game plan. Doing nothing is but one option.
Right brain, left brain, action.
The first step — control your emotions
Put the right side of your brain to work. Controlling your emotions is critical especially when there is nothing you can do about the situation.
Stock market corrections often come out of nowhere, but we beat ourselves up believing that only an idiot would have not seen the coming train wreck.
Stop right now! Stay calm, focus on the good in your life and realize that money lost or gained in the stock market is only as good as what you intend to do with it.
Money lost in a correction is what economists call a sunk cost. Despairing, feeling bad about what you should and could have done solves nothing. The market certainly does not care and neither does anybody else.
Being reactionary and selling all your stocks at the first sign of trouble requires a magician’s touch.
So, best to remain calm and find your emotional center.
Corrections don’t always turn into prolonged periods of despair and many times are short lived.
That is where doing your homework comes into play.
The second step — analyze the type of stock market environment you are in.
Not every correction turns into a nasty bear market like 2008. Most corrections last one or two weeks. Some, unfortunately last a bit longer.
Knowing what type of correction you are in is important. Nobody will come down from the sky and give you the answer.
But you are not totally at the mercy of the gods either. That would be a cop out. No excuses — put the left side of your brain to work.
You can do your homework. Read, listen, analyze and digest recent events.
Do this one trick. Go back a couple of weeks before the crisis and read what market strategists were saying at that time. If all was rosy back then, ask yourself what has changed in the last couple of weeks.
If something significant has changed such as the country entered into a war or the economy has collapsed, then some apprehension is probably justified.
If nothing has changed, then the truth is that nobody knows what has caused the stock market to react this way. It could be a lot of things, but “I don’t know” is probably the most intellectually honest answer.
Generally speaking, there are three types of stock market corrections.
- Technical — this type of correction typically comes out of nowhere and takes market participants by surprise. One bad day for the stock market turns into 2 or 3 in a row and soon enough there is an avalanche of pundits predicting the next global crisis
Technical Corrections tend to last only about a week or two. In the context of long-term capital market history they barely register to the naked eye. Boom they are gone, and people quickly forget what they just went through.
- Economic — caused by the business cycle, i.e., periods of economic expansion followed by recession and eventual recovery
Typically, the clues as to whether the economy is heading into a recession are present ahead of time.
Usually a large number of economic indicators will point in the same direction. For example, confidence surveys start showing some downward trends, and layoffs start accelerating in cyclically sensitive sectors of the economy.
- Structural — these are the most severe type and involve periods of real economic and financial stress. Something has gone off the rails and stock markets are the first to feel the brunt
The integrity of the entire economic and financial system is at stake. Without decisive fiscal and monetary policies there is a risk of total economic collapse.
Figuring out whether the stock market is in a technical, economic or structural correction has important implications for your financial health
Do you think that we are on the verge of another crisis such as the one back in 2008? Then, unfortunately, you are in a structural correction. Take cover.
Do you think that the economy is slowing down and that we are on the verge of another recession? Then, you are in an economic correction.
Is this correction a total surprise and nothing make sense? The economy is OK and until recently everybody was confident. Then, most likely, you are in a technical correction.
Each type of correction calls for a different response. Time to act.
The third and final step — take action
One option always available to investors is to do nothing. But doing nothing should be based on what your homework says.
Doing nothing is a good response only if you concluded that you don’t get what’s going on and that things seem pretty much the same as before the crisis.
In other words, doing nothing is just fine if you concluded that the equity market is in the midst of a technical correction.
But what if you concluded that the world economy was close to collapse? Under this scenario which by the way has happened only twice in the last century, you should take immediate action.
If your analysis points to a structural correction, watch out. Things will be getting much worse before they recover. And the recovery will take a long, long time.
In a structural correction, it’s best to sit with cash or hard assets such as gold, farmland, timber— anything but stocks.
Selling everything takes guts not to mention a lot confidence in your ability to predict doom and gloom economic scenarios.
Total economic collapse is a rare event in the context of global economic history. The 1929–39 Great Recession comes to mind. Most recently the 2008 Financial Crisis could have turned out much worse had monetary policy not been as aggressive.
Finally, what if your conclusion was that the economy was headed for an old fashioned business cycle recession?
Economic recessions luckily don’t appear overnight. The evidence slowly builds up.
First, it is anecdotal evidence. The local mom and pop store down the street closing down. More “For Sale” signs around your neighborhood and stories of people losing their jobs.
Then, the evidence appears in the hard economic numbers. Unemployment claims trend up, retail sales start lagging, etc. This is the stuff that the Wall Street Journal loves reporting.
If your homework points to an economic correction don’t panic. Safer assets such as bonds hold their value much better than stocks during the early phases of a business cycle correction.
Stocks tend to do poorly at this stage as companies struggle maintaining their profit margins and revenues usually take a dip.
No need to panic especially if you are a long-term investor. Do two things.
One, lighten up a bit on your stock holdings. If you got a bit greedy and let your stock investments run during the bull market bring your holdings back to a level more consistent with how much pain you can endure as the equity market winds down.
Second, focus your investments on sectors that do not rely to any large extent on economic growth. People still need to eat, right? Food companies, personal goods, basic necessity, and utility companies tend to hold their value during recessions.
Equity market corrections are never pleasant. How you react to them could greatly affect your financial health.
But playing the victim is not a choice. I recommend three steps to gaining control over the situation.
- First, calm yourself down. Regain your emotional equilibrium.
- Second, determine what is really going on in the economy and markets. You don’t need a PhD to do this — common sense and a level head are much more important. Figure out whether you are in a technical, economic or structural correction.
- Third, be conscious about making a decision. Maybe you don’t do anything at all. Maybe you dump all your equities. Or, maybe you do something in between. Take action based on your homework. You might not be right, but you have at least done the best you could!
Make your money work for you — your goals, your aspirations — it’s your life after all!
Be proactive about your financial health — it’s a big part of your life.
If you are interested in a more in depth discussion of this topic please click on my original article, Corrections, Recoveries and All That Jazz.
None of this shall constitute an investment recommendation. Consult your wealth manager if you need help.
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