Market's Manic Monday; Or, How I Learned to Stop Worrying and Love Long-Term Investing

When stocks take a dip, people tend to get a bit flustered. Rest assured, these corrections are a very necessary part of economic stability. Strategy is the name of the buying game, and today our experts offer some insight to some common misconceptions. 

A full transcript follows the video.

Gaby Lapera: Market correction strategies. This is Industry Focus.

Hello, everyone! Welcome to Industry Focus, financials edition. My name is Gaby Lapera and joining us this week is John Maxfield on the phone. We're officially in market correction territory. The official definition is 10% down from the recent high, and we're down 10.5% as of this morning.

The first thing I want to say is that this is actually great news, especially if you're prepared with a good strategy; which Mr. Maxfield is ready to inform us about.

John Maxfield: Let me just tell you this, Gaby; as soon as I woke up this morning, the first thing I do is check the Wall Street Journal. I think the headline article was that the Dow was down 1000 points.

Lapera: That's terrifying.

Maxfield: Even for someone who's lived through the financial crisis and been cognoscente of it, that's a pretty large drop. It's far from eliciting feelings or emotions of fear. For me it elicited feelings of opportunity because someone like myself, has been sitting on the sidelines watching stocks going up and up over the last few months. I've put money into my SEP IRA to reduce last year's taxes.

I haven't seen a buying opportunity until now. Now I think it's fantastic. For a lot of our listeners this is going to be very familiar. If you want to be a successful investor you've got to act counter-cyclically. When stocks go down, that's when you buy. When stocks go up, that's when you sell, or you hold.

This is the type of thing that people like us wait for. The question is then, how do you actually execute a buying strategy? Do you take all the cash that you have, plus whatever margin that you have and dump it into the stock market? Is there a better, more realistic and reasonable approach to doing that? That's what we should really dig into.

Lapera: Okay. For a lot of our listeners who are long-term investors, you bought the companies because you thought they were going to succeed in the long term. Selling them now is crazy because they're not down because they're bad companies; they're down because the whole market is down. It's not because there's something intrinsically wrong with them.

Maxfield: That's right. If you look at Johnson & Johnson (JNJ 0.67%), and P&G (PG 0.86%); these are companies that could go bankrupt just as any company could. A meteor could hit the planet which would be unfortunate for stocks as well. The chances of that are pretty small. These are big, powerful, extremely well run, extremely profitable companies that we as individual shareholders can take advantage of by owning them. You get your dividends, you also get your stock price appreciation.

Over the long term, the population is going up, the economy grows, and it's been that way since the beginning of mankind. Why would think that's ever going to stop because stocks are down? Even if they were still down 1000%, just to get down into the important part of this; it's the strategy of how you go about buying stocks when the market is down this far.

It's my opinion that the way you do this -- and I've done this a few times leading to mistakes and benefits doing this -- as opposed to pouring all your money in at the exact same time, you want to average down into a position. I cover banks, so I'm thinking about Bank of America (BAC 1.53%). I'm not going to buy because I talk about it too much and I can't get around our disclosure policy, but I know its share price really well.

Let's say it's trading at $15.50 today and tomorrow it goes down to $14.50. Today you want to buy 1/3 of your available cash that you want to dedicate to that position, tomorrow you buy another 1/3, then on Wednesday you'd buy another 1/3. By averaging down, that protects you in case the market continues to go lower.

That gives you the opportunity to follow that stock down and get a lower basis in that stock, as opposed to buying in today and seeing that tomorrow it goes down another 5% and then you get depressed. That's a horrible feeling; I've been there before. You want to avoid that.

Lapera: Are there any potential issues with this strategy?

Maxfield: One of the potential issues with this strategy is if the market immediately rebounds then you've lost your opportunity, but this is all about reign-fencing risk. How do you make decisions to profit, while also taking into consideration the risk of doing so? You have to balance those two things. By averaging into positions that's a great way you can take advantage of the fear in the market, but do it in a responsible way from a risk perspective.

Lapera: I think something we should also talk about is that although market corrections inspire a lot of fear, it's not like they're abnormal events. They happen all the time. Someone did the numbers on this and we average a correction every 357 days. That's about once a year, or so.

Maxfield: You're probably talking about Morgan Housel who's great when it comes to providers for The Motley Fool. I hope he's listening. He has a kid on the way, so if you are listening, Morgan, good luck with that. That's going to be an amazing experience. One of the things that Morgan showed in his research is that the market has declined by 10% or more on average roughly 11 months.

Even though the market is down 10% right now from its recent high, this is a pretty common occurrence.

Lapera: Honestly, we're saying this with the full knowledge that it's impossible to time a market correction. We want a super long streak of the market continually going up. It's been 1000 days since it's gone down, which is a really long time if you think about it.

Maxfield: It's a pretty epic, bull market ever since the financial crisis, which shouldn't be that surprising because that was the worst economic crisis since the great depression. At the same time, stocks can't just go up forever. At some point they've got to correct and come back up and take into account what's going on in the economy and all those things.

Lapera: The other thing to think about is that market corrections don't last forever. They'll last about 2.5 months on average, but it's not going to be 30 years. I read an article this morning that said "This is going to be a generational recession starting today."

Maxfield: Maybe they're right. I seriously doubt it.

Lapera: They could be right.

Maxfield: The reason that people write headlines like that is because fear elicits people to take actions and one of the actions that people who write articles want is to have people clicking on their articles. You have to reduce that noise and really focus on what matters. That is, to be a successful investor there are a couple things you need.

First you need a long-term approach. Second, as a general rule, you want to act counter-cyclically. When everyone else is scared, that's your opportunity.

Lapera: This is actually a great time. If you're nervous, this is a great time to hold onto what you have. There's no reason to freak out. This is all speculation at the moment, but do you want to talk about why this is happening?

Maxfield: The consensus story about why this all is happening is that it's all emanating out of Asia, China in particular. China's economy has had a lot of concern over the last few years about it overheating, and an eventual recession or decline in its GDP growth rate. For a company with its living standards and the size of its population and the possibility for social agitation; as a government you really want to avoid that type of situation.

Over the past couple of weeks, to offset what appears to be weaknesses in its underlying economy, China's central bank has been lowering the value of the Chinese currency relative to other currencies in the world. That's what ignited all this concern. That goes against what China's central bank has been doing for over a decade in terms of trying to normalize the yuan's value to introduce it to global currency markets in the same way the U.S. dollar is used by all these countries as a principle trading currency.

That reversal of the Chinese central banks part seems to have been the straw that broke the camel's back, if you will.

Lapera: Can I ask you about the U.S. dollar? The U.S. dollar has been really strong the last year, or so. I understand that the Federal Reserve is trying to weaken the dollar a bit to help our exports; to boost up our economy. Does this fit into China at all?

Maxfield: There's a great irony with the U.S. dollar in terms of its strength in the global currency markets. That is that after the financial crisis the dollar has been super strong. You think "Why would the dollar be so strong if the financial crisis was in the United States?" If that's really where the heart of it was. The answer is, even if the United States goes through a severe economic downturn we're still the safest place to keep money in the world.

The money still floods in here. What the Federal Reserve has been doing over the last few years is trying to help the economy out; get back up to that full employment level which the Federal Reserve defines as between 5% and 5.2%. in order to do that it's been doing a number of different things, but it's lowered interest rates super low, and it's also gone through three rounds of quantitative easing.

Quantitative easing is when the Federal Reserve goes out and buys long-term fixed income securities on the market in order to increase the price and thereby bring down their yield. By bringing down their yield you're lowering your borrowing costs. One of the other things that these do -- and the question is whether or not the Federal Reserve is intending to do this, or if this is a happy consequence -- is when you lower your interest rates so far, and you do quantitative easing, one of the implications is that you're going to be pushing your currency down.

You have the U.S. trying to push its currency down -- and this is just a presumption -- you have the U.S. trying to push its currency down to increase its exports, you have China doing the same thing, and then in Europe, well, Europe is just a basket case right now. You have all the things going on with the euro, and a lot of people are speculating that you have a bit of a currency war going on right now in terms of everybody trying to save themselves through that currency mechanism. But because everyone is doing it, it's probably not going to be overly effective.

Lapera: Right. There's been a lot of speculation that the Fed might raise the short-term interest rates by the end of the year. Do you think they will still do that as a result of all this going on?

Maxfield: It's impossible to predict what the Fed is going to do. I've never been able to. I've never seen stats on anyone that's been able to do it correctly.

Lapera: There's an octopus in Germany who was able to pick the World Cup winners. Maybe we need an octopus for the Fed.

Maxfield: It's got eight arms. If you have eight arms, what can't you do? You could certainly control monetary policy.

Lapera: It's a good thing they can't walk on land.

Maxfield: That's true. You could put a big tank in there. Just have him sit there with eight calculators. To answer your question, it's impossible to predict what the Fed is going to do. However, we've long assumed that at some point the Fed is going to increase interest rates.

Lapera: They're really low right now, which is why we're assuming that they're probably going to go up. They're probably not going any lower than they already are.

Maxfield: Short-term interest rates -- the Fed funds interest rate, which banks lend to each other on an overnight basis and is the key U.S. interest rate benchmark -- that has been nearly 0% since the financial crisis, which is unprecedented in the history of the United States. We've seen this in Japan for a decade and a half or two decades, but in the United States we haven't seen that before.

The question is: at what point will the Fed increase that? The Fed has been saying all along that as soon as they see positive signs in the economy and unemployment continues in the right direction, plus inflation moving up to that 2% threshold that they like to see for a healthy economy; that's the point where they would feel comfortable raising rates.

If China's economy continues to do what it's doing, and those concerns continue to build and there are legitimate concerns; I would have a hard time understating how the Federal Reserve would feel comfortable raising interest rates under that circumstance. However, I could be totally wrong on that.

Lapera: This whole back half of the episode was entirely speculative, just for our listeners out there. It's fun speculation though. I'm glad you managed to make it to the end of this podcast. Thank you very much for joining us, and we'll see you next week.