Stock Market Correction: Is It Worth Waiting For?

Few things are scarier for smart investors than buying when stock markets are at all-time record highs. With the S&P 500 (^GSPC -0.58%) having soared to new records yesterday, sentiment among mainstream investors is unmistakably bullish. But subtler signs of nervousness have started to appear about the health of the economic recovery and the ability of the bull market to continue, raising fears that a stock market correction is imminent.

Ordinarily, investors can expect to see drops of 10% or more in the market roughly once a year, even in the context of an ongoing bull market. But the S&P 500 hasn't suffered a 10% pullback since December 2011. With such a long period having gone by without a stock market correction, does it make sense to hold off on buying stocks in hopes of getting lower prices? Or should you go ahead and buy, risking getting mauled by a big bearish move?

Photo: Alan Vernon, courtesy Wikimedia Commons.

Are you ready for what you're wishing for?
Whenever there are extreme market movements in either direction, emotion starts to play a huge role in investing decisions. Extended and uninterrupted stock-market rallies, as we've seen throughout the past two years, leave those on the sidelines feeling increasingly worried that they've missed out on huge potential gains. This pushes them to invest even as higher share prices make stocks less attractive from a valuation standpoint. In that light, waiting for a correction might seem like the smarter move.

Yet, waiting creates two more challenges. First, you have to have the patience to stick with your decisions, and that can be difficult if the bull market rages higher. For instance, at the beginning of 2013, markets soared after lawmakers averted the threat of a huge tax increase on the entire American public. Those gains led some to decide to wait for a pullback before getting in. They've been waiting ever since, and the S&P 500 is now 20% higher.

Second, once the correction comes, you have to have the conviction to follow through with your original commitment to buy. That's also a tough thing to do, because most stock market corrections hinge on some piece of exceptionally bad news that can make less secure investors question their entire investing plans.

Two smart moves to make now
What makes the most sense is never to stop investing entirely, even as markets keep rising, but also to keep your eyes open for better prospects if a stock market correction occurs. That way, you'll benefit no matter which way the market moves.

When considering investments at near-record levels, it often pays to focus on areas of the market that most investors have neglected. Lately, consumer-staples stocks have gotten a huge amount of attention, with many investors turning to them for their reliable dividend income and defensive characteristics during pullbacks. Yet all the demand for dividend stocks has pushed their valuations up dramatically.

By contrast, commodity stocks, like gold miners and fertilizer producers, have gotten hammered. In the potash fertilizer space, PotashCorp (POT) and Mosaic (MOS -0.43%) plunged during the summer when a key player in the global potash market backed out of a cartel agreement with its main partner, spurring speculation that potash prices would drop severely. It's true that neither Mosaic nor PotashCorp owes its entire fortune to the potash industry, given that both also make other products that don't rely on potash. Yet, short-term traders sold first and asked questions later, expecting the worst, and not wanting to get caught up in ongoing drama in the industry. For long-term investors who can afford to handle near-term uncertainty, the arguments favoring greater demand for crop-enhancing products like potash remain unchanged, and that should help Mosaic and PotashCorp recover eventually. That makes the two stocks worth looking at for their potential value opportunity.

At the same time, though, it also makes sense to look for stocks you'd want to buy if a stock market correction actually happens. Procter & Gamble (PG 0.65%) has a lot of growth potential from global markets, but at 21 times trailing earnings, the shares reflect a premium for its 3% dividend yield and reputation as a defensive stock. Investors appreciate P&G's brand success and its reliable demand from customers who see its products as essential staples. But paying too much for even the highest-quality consumer stock doesn't make sense, especially when Procter & Gamble hasn't yet delivered on its promise to expand its earnings power more rapidly. After a stock market correction, though, P&G shares could look a lot more attractive for the long run.

Be correct about a correction
Stock market corrections happen, and it pays to be ready for them. But you also have to be ready for them not to happen on any predictable time frame. Your best solution includes making the most of current opportunities while also setting the stage to jump on cheaper stocks when they emerge.

Tune in to Fool.com for Dan's regular columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.