After weeks of plunging stock prices on global equity markets, two age-old questions that always accompany such market malaise have come to the fore: (1) Why is the market going down? (2) Is the correction over?
Put another way, investors are eager to learn whether it's safe to invest in the stock market again, or whether they should pull out of stocks. Market experts are equally eager to give them sage advice.
Is it all about interest rates?
So why are stock markets down the world over? I know that rising inflation expectations and higher interest rates in the United States have been held responsible, but rates have been rising for more than a year and a half now. In fact, the 10-year Treasury bond rate has barely moved in the last four weeks, when the market downturn has been most pronounced. The honest answer to this question is that we can point to no proximate reason that accounts for dropping stock prices. Like all market declines in history, this one can be attributed to a collection of small news items destabilizing markets that were close to the tipping point to begin with.
Is it time to buy again?
But is the correction over? That's an equally difficult question to answer, simply because there is no identifiable cause for the market drop. If there were, we could calibrate our responses accordingly. In other words, if stock markets are down globally because interest rates in the U.S. are rising, they should stop going down when rates stop going up.
That doesn't stop us from trying to second-guess markets, though. We're all market timers at heart, and we draw on the tools that researchers and analysts have concluded are useful in forecasting future market moves. Some of these tools can be categorized as technical indicators -- chart patterns and volume measures. Some are fundamental and include value comparisons: Comparing the earnings yield (the inverse of the P/E ratio) to the Treasury bond rate is one example. Proponents of these measures point to their unerring accuracy in predicting market movements, but here comes the bad news.
First, these indicators, be they technical or fundamental, have very high error rates. Even the best of them are wrong almost as often as they are right. Second, even those indicators that get market direction right almost never get the timing right. Thus, fundamental indicators would have shown the market to have been overvalued in 1998, but the correction didn't occur until two years later.
Five tips for a down market
So, what's a stock market investor's best response to dropping stock prices?
- First, forget about rationalizing and explaining (or listening to other people explain) why stocks are falling. It's a pointless exercise at best, and misleading at worst.
- Second, file the painful experience away as a worthwhile reminder of the riskiness of stocks, and draw on that memory during the next market boom when optimistic market seers tell you that stocks are really not risky (Remember Dow 36,000!).
- Third, if you believe, based on your preferred market measure, that stocks have overcorrected, don't wait for the correction to end. Investors who wait for final and complete confirmation that the market has turned around invariably miss the bulk of the turnaround.
- Fourth, recognize that even if you're right about the market overcompensating for past mistakes, there will be months of pain before the gain. Being a contrarian is easy on paper but much tougher in practice.
- Finally, console yourself with the recognition that the professional portfolio managers and the market experts you see on television are staring into opaque crystal balls.
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Fool contributor Aswath Damodaran is a professor of finance at the Stern School of Business at New York University. An enthusiastic teacher who has been voted Professor of the Year by the graduating MBA class five times during his career at NYU, Professor Damodaran also provides a wealth of outstanding content on his website. Among his numerous books, Fools might be interested in Investment Fables and Investment Valuation . The Fool has a disclosure policy.