“The market is overbought – a correction is inevitable!”
I’d been hearing this prediction for months.
And I was getting ever more annoyed by it.
Not because I thought it was wrong… but because I know corrections are just a normal part of investing.
Markets never go up in a straight line. And as sure as night follows day, a market’s rise will be punctuated by pullbacks.
Investors tend to forget this.
That’s because their memories play tricks on them.
Here’s my favorite example…
If you’re like most investors, you probably think of the dot-com boom as a single uninterrupted rise in the markets.
But if so, you’re wrong.
During the dot-com boom of the late 1990s, the Nasdaq saw five roughly 10% declines before its eventual collapse.
And a 10% fall in the Nasdaq index meant even larger declines in more volatile stocks.
During each of these corrections, investors had to decide whether staying in the market was the right thing to do. Those who exited lost out on the raging bull market’s biggest gains.
Corrections have another thing in common: They always come out of the blue.
The current correction is no different.
After all, look behind the headlines, and the stock market’s fundamentals remain solid.
Earnings have been strong. The U.S. market may not be a bargain, but it’s not incredibly expensive either. The S&P 500 is trading at 16.4 times next year’s earnings.
Second, the U.S. economy is not in recession – nor do any indicators suggest it is on the verge of entering one.
Third, both the fourth quarter and third year of the presidential cycle point toward strong seasonality.
Still, investor sentiment could hardly be worse.
My favorite sentiment indicator – the CNN Fear & Greed index – has been stuck in “extreme fear” for almost two weeks. It’s also one of the most reliable indicators of an imminent rise in the markets.
But the market has yet to turn. Something has to shake investors out of their pessimistic mood.
I see three catalysts in today’s investment landscape that could kickstart investor sentiment and allow for stocks to rebound.
First, a strong Republican showing in the November 6 midterm elections could energize investors. With its tax cuts and deregulation, the Trump agenda is bullish for U.S. business. A Republican victory would signal more of the same.
Second, the Fed could turn more dovish. A signal that the Fed might slow its interest rate rises would go far toward soothing investors’ nerves. After all, it was an accommodating Fed that put the brakes on tumbling stock prices in the market corrections of 1987, 1998 and 2007.
Third, a resolution of the U.S.-China trade war would also reduce global uncertainty and strengthen sentiment toward U.S stocks.
Here’s the challenge…
None of these developments appears imminent.
The gut-wrenching correction could continue for a while.
So what’s my advice?
To start, don’t throw in the towel and go to cash. Once sentiment shifts, the market will rebound like a coiled spring. Miss just the best 10 days in the market, and you could easily halve your long-term returns.
If you’re trading the market actively, reduce your bet sizes. Corrections are as much about managing your psychology as they are about managing your money. Playing smaller will keep you in the game while limiting your risk.
In your long-term portfolio, market pullbacks are an excellent time to rebalance your holdings. Buying stocks while “on sale” is an easy and reliable way to boost your long-term returns.
In the meantime, keep in mind another comforting truth about market corrections…
There’s never been a market correction that didn’t end.