Source: Flickr user Rafael Matsunaga.
August gave investors a harsh reminder that they hadn't had in almost four years: Stocks can actually go down.
A stock market correction really isn't that rare of an event. Since 1950 the broad-based S&P 500, which is the best gauge of the health of the U.S. stock market, has witnessed 33 corrections of 10% of more. Altogether, prior to our latest correction, the stock market has spent close to 6,600 days officially in correction territory.
What's different about our latest stock market correction is simply the length of time since the last one; it was a much longer delay than the historical average. If this demonstrates anything, it's that timing the market is a fruitless venture.
You can't fight the inevitable
Corrections will happen whether we want them to or not. We'd like to think that the market can go up forever -- and historically, it has outperformed all major investment types over the long run, even with every correction included -- but if you want to invest in stocks, then you have to embrace the reality of stock market corrections.
Why are stock market corrections inevitable? I'd suggest three factors play a role.
Source: Flickr user Francesco.
1. Emotions
Arguably the biggest problem for the stock market is that it's difficult for investors to separate their emotions from their investments.
Some investors have no trouble tuning out their emotions, and they tend to be very successful. Think about Warren Buffett, who focuses on buying great companies with products that essentially sell themselves. He buys with the intent of holding for long periods of time and does not let a correction, or even a few bad quarterly reports, shake his investment thesis. His $70 billion net worth would suggest this strategy is working well.
However, the vast majority of investors tend to have a short-term mindset. A recent survey from financial advisory organization deVere Group noted that a whopping 71% of respondents only plan their finances for up to one year ahead. Without a long-term mindset, investors are liable to let modest downward moves (even an intraday decline of a few percent) scare them into making rash decisions, rather than examining the long-term outlook of a stock they own. These rash decisions can manifest as a rapidly declining stock market from time to time.
Source: Flickr user thetaxhaven.
2. Disregard for risk leads to overvaluation
Another component that leads to inevitable stock market corrections is investors' willingness to pay a premium for stocks during a bull market.
To state the obvious: This is something of an extension of the hazardous emotions discussed above. Just as emotions can drive stock prices lower, they can also push them higher than their fair valuation during a bull market.
I suspect this is the case because investors want to take advantage of higher growth, and even riskier growth opportunities, when the stock market is firing on all cylinders. You'll typically notice during bull markets that investors are more willing to overlook fundamental flaws such as an exceptionally high P/E ratio or cash outflows so long as companies are reinvesting for the future in high-growth sectors. Recent examples include biotech and tech stocks, which have generally traded at premium valuations during this bull market. Typically, the unreasonable risk-taking of investors will lead to unrealistic growth expectations, causing a correction in stock prices.
Source: Federal Reserve Bank of New York.
3. Cyclical nature of the economy/Fed effect
Finally, the natural peaks and troughs of the U.S. economic cycle, coupled with the decisions imposed on monetary policy by the Federal Reserve, are likely to contribute to a stock market correction at some point.
Take the Federal Reserve, which can change U.S. monetary policy in three ways -- adjusting the discount rate, buying or selling U.S. Treasuries, and regulating the amount of capital that U.S. banks are required to hold. Unfortunately for the Fed (and investors), the Fed is working with a lot of lagging data, meaning its adjustments to the economy are made after the fact. Data such as prior-quarter GDP, income and wages, the unemployment rate, and the Consumer Price Index can all be months old but still influence Fed policy decisions. These Fed policy changes aren't designed to keep the U.S. economy out of a recession so much as to keep growth as steady as possible during the good times and minimize consumers' and investors' pain during the recessions.
Long story short, stock market corrections are an inevitable part of investing. So long as you're investing in high-quality businesses that have discernible long-term growth outlooks, then a stock market correction is nothing to fret over.
