Corrections and the Nature of the Markets

Currently, markets around the globe are ‘selling off’ due to worries ranging from trade policies and tariffs to rising U.S. interest rates to geopolitical concerns. Rather than be alarmed, however, we should consider whether this is merely a return to more “normal” conditions and not necessarily a sign of worse to come.

Why do we say a return to more “normal” conditions?

First, let’s think about the nature of investing and the relationship between risk and return. Also, remember that risk and uncertainty are related: the latter brings about the former, and with more uncertainty, the potential for future payoff may also be greater.

We have all been vulnerable to forgetting the nature of risk and uncertainty in the markets; the Central Banks interventions into the markets has pushed the stock market seemingly straight up since March 2009, with just a couple of corrections in between.  With higher expected returns, we should expect volatility, as that is the mechanism through which investments ultimately find their true value. When discussing corrections, we should consider three basic issues:

Why they exist,
Why they are natural, and
Why they are necessary.

Corrections (when they occur) exist because facts become more widely known and understood, or alternatively, they change altogether. News flows are constant and are almost always unpredictable. Random events confound even the most carefully-made forecasts, which then must be discarded. Conventional wisdom is re-examined, and new data provides investors with deeper ways of thinking about an investment, or even the markets as a whole. Armed with fresh knowledge, investors may change their minds. And that may mean responding with “sell” instead of “buy.”

Market movements are natural because the data does change and people, in turn, change their minds in response. In a static world, there would be no corrections – nor would there be many opportunities, either. In that world, all investments would always be priced at their “fair value” and would never deviate in a way to provide an entry point to buy a new opportunity. Investors constantly research, analyse, and evaluate investment opportunities. Information on those opportunities is constantly being released and thus is constantly changing.
Being early to capitalize on that changing information means some investors are quick to act – and when they all act at once, then the market may either surge higher or plunge lower. It is a natural course of action for market participants, upon realising the same new information, to act quickly to buy or sell.

Corrections are necessary because it is through this mechanism that risk is fairly priced. What do we mean by this? Quite simply, stocks, bonds and other investments are determined by what investors are willing to pay for them; this depends in turn on what people expect will happen in the world. The more uncertainty there is, the lower the price one is willing to pay for an investment, because there are more ways that the investment can be pushed off course. In this situation, most investors want a greater degree of protection when buying a stock – and that means a lower price. A correction, thus, is a way in which a sign that says “Special! Sale Now On!” is hung over the market, perhaps signalling buying opportunities. Indeed, it’s often the time when many investors go shopping for things they might not otherwise have bought when they were more expensive. It’s simply how the market works, much as in a department store.

In fact, it’s completely abnormal not to have corrections. We’re quite overdue, in fact. We’ve become complacent, forgotten how they feel or even what they look like. Having one, or even more of them would be a return to normal. In this case, “normal” means an environment with more volatility; that is, the very thing which investors undertake in order to receive the returns they expect. It’s a natural, expected, and customary trade-off.Of course, bear markets are also normal and useful, however much we dislike them. We will have another, but nobody can predict in advance when the next might occur. Historically speaking, using monthly data since 1869, Ned Davis Research details that the typical bear market lasted about 17 months on average and delivered a -38% return, not annualised. But the good news is that between bear markets, bull markets lasted for almost nine years, having delivered an average return of over 17% per year.

Having discussed the nature of a correction, what does it not mean?

For starters, it generally isn’t anything to be overly concerned about, for reasons we just explored. It also doesn’t necessarily signal any broader problems with the market or the economy. We can – and often do – have a solidly growing economy and corrections that occur amid those expansions.

What a correction in the current environment might mean is that investors looking under the surface discover there actually is uncertainty in the world, after all. This is true even if reasons for optimism about the economy abound. And since there is always plenty of uncertainty in any environment, you will probably see more ups and downs going forward.

Having more ups and downs and returning to a more normal investment certainly should not prevent you from being optimistic. Moreover, a return to a more normal level of volatility should not be a reason to discard a carefully put together long-term investment strategy. We are here to help you stay the course, if that is right for you. If you have any questions or concerns, or would like to revaluate your investment strategy, please do contact us.

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