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Investors Are Better Off In a Stock Market Correction

By Alex Dumortier, CFA – Feb 25, 2016 at 1:42PM

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Long-term investors ought to lament the fact that stocks are exiting a correction.

U.S. stocks are little changed in early afternoon trading on Thursday, with the Dow Jones Industrial Average (^DJI -1.11%) and the S&P 500 (^GSPC -1.03%) up 0.51% and 0.33%, respectively, at 1:24 p.m. ET. On Monday, the Dow climbed out of correction territory before falling back into it (but we're back out again today), with a correction defined as a minimum 10% pullback from the high. For the Dow, that puts the threshold at 16,516.26.

Federal Reserve Bank of St. Louis president James Bullard. Image source: public domain.

That's undoubtedly reassuring to many investors (and even more traders), but while no one enjoys seeing losses in their portfolio at any given time, most equity investors will be better off when stock prices go down and stay down. To see why, let's listen to Federal Reserve Bank of St. Louis president James Bullard, who told CNBC this morning:

If you look at the Wilshire 5000, it was increasing at a rapid pace all through 2013, 2014, up until January 2015. If it had continued up at that same pace, we'd be sitting here talking today about a bubble in U.S. equities. That isn't what happened, [it] sold off, now we're about 10% down from where we were [in] January 2015... I think it's better pricing than it was: If we had continued to go up at that same pace, that would have been an asset pricing bubble. You're [now] closer to fair value.

[Note: Containing all U.S. headquartered equities "with readily available prices", the Wilshire 5000 Total Market Index is the most comprehensive measure of US stock market performance.]

While elevated stock prices/valuations might make you feel good in terms of your perceived stock market wealth, they also reflect higher prices on the stocks you're buying.

The first question you need to ask yourself is: "Am I currently a net buyer of financial assets and, more specifically, of equities?"

If you are still saving for retirement, then the answer to that question is almost certainly "yes."

Now ask yourself this: "What prices would I prefer to pay for the stocks I'm currently buying: Inflated prices or depressed ones?"

If you're focused on your long-term returns and maximizing long-term wealth accumulation, the answer, without doubt, ought to be the latter. Indeed, paying inflated prices will only harm your expected returns. Depressed valuations, on the other hand, add a kicker to the expected returns from earnings growth and dividends (assuming valuations normalize, which they invariably do).

You might respond that the stock market goes through cycles of under- and over-valuation, and therefore if you're a regular buyer of stocks through both phases, then it'll all come out in the wash.

However, that reasoning is incorrect because it ignores one critical asymmetry between the two: Unless you adjust your purchase amounts to favor periods of under-valuation, an equal dollar amount buys fewer shares (i.e., a smaller ownership percentage) when valuations are inflated than when they are depressed.

Rather than rejoicing that stocks have exited correction territory, savvy long-term investors ought to be lamenting the end of the equity clearance sale. This year's stock market swoon has provided some of the best buying opportunities since the market low of March 2009. Why would any sensible investor want to see those bargains disappear?

Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Dow Jones Industrial Average (Price Return) Stock Quote
Dow Jones Industrial Average (Price Return)
^DJI
$29,260.81 (-1.11%) $-329.60
S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
^GSPC
$3,655.04 (-1.03%) $-38.19

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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