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Corrections are a regular part of the market
Halloween is still two weeks away, but that hasn’t stopped global stock markets from striking a note of terror in the hearts of investors. After stock indices sleepwalked their way to record highs last month, blissfully oblivious to all the terrible, awful events unfolding in the world—the spread of both Ebola and the equally vile Islamic State, Russia’s continued aggression toward its neighbours (remember that time Putin-backed rebels blew a passenger plane out of the sky?) and a generally crummy outlook for global growth—it’s as if the collective weight of all that negative news finally became too much. Optimists have once again given way to doomsayers, greed to fear.
Which, as we’ll see, is generally right about the time when sound investment strategies give way to stupid.
The carnage in markets has been spectacular. In the span of less than a month, the S&P 500 index has shed seven per cent of its value. It’s been worse in Canada, with the energy-dependent S&P/TSX composite index down 10 per cent since its September peak, anchored by falling oil prices. The market volatility index, otherwise known as the VIX and even better known as the fear gauge—a measure of the expected volatility of U.S. stocks— has surged to the highest level in more than two years. Meanwhile, CNNMoney’s fear and greed index, which, in addition to factoring in the VIX, also tallies a number of other market indicators such as market breadth, stock price strength and the demand for safe havens, just hit its gloomiest “extreme fear” level.
Let’s get one thing out of the way first. Corrections are a regular part of the market, despite what the last two years might have led some to believe. In each of the years 2010, 2011 and 2012, the S&P 500 endured corrections of between 10 and 19 per cent. Clearly this correction could still have a long, painful way to go.
There were also ample warning signs this rout was coming. Stock market valuations had become stretched. Margin debt, the money that investors borrow to buy stocks, had reached new highs (the last two times that happened were just ahead of the dot-com crash and the 2008 financial crisis). Perhaps more important, investors had become overly complacent. The geopolitical risks that have been swirling around the globe this year are as bad, or worse, than the prospect of Greece defaulting on its debt, and yet, the European debt crisis regularly pummelled markets. But, until this correction, nothing fazed investors in 2014. That’s not a sign of resilience; it’s a dangerous and foolish disregard for risk.
Now that stock markets are finally in correction mode, though, it’s a certainty that some investors will panic and inflict damage on their portfolios. We’ve seen it before and we’ll see it again. In August, the investment firm Richard Bernstein Advisors compared the performance of the average investor—based on the monthly flows of money in and out of mutual funds—against a variety of stock indexes, commodities and other asset classes over a 20-year period ending Dec. 31, 2013. Not surprisingly, the average investor fared poorly. The shock was how poorly.
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By moving in and out of the market, Joe Stockpicker managed an average return of little more than two per cent a year over those two decades, compared to an average annual return of around nine per cent for the S&P 500 index (even after the market crashes of 2000 and 2008). It proved, once again, that investors are terrible at timing the markets and that what matters most in creating wealth is time spent in the market. As Richard Bernstein wrote, “They bought high and sold low. When chaos occurred, investors ran away.”
What we’re experiencing now is chaos, but that’s no reason to dump everything and flee. It may even provide buying opportunities. If one were optimistic about equities as a long-term investment four months ago, there are as many reasons to remain so, now that markets are at 10-month lows. Yes, a clutch of weighty organizations have recently lowered their economic forecasts for global growth, but the IMF and the OECD had already cut their outlooks in 2013 and again early in 2014. What’s more, the U.S. economy is showing remarkable strength. America’s federal deficit is shrinking fast. The rebound in its job market is picking up speed. And cheaper gas at the pumps, courtesy of lower oil prices, will come as a form of fiscal stimulus for consumers in both the U.S. and Canada, leaving more money in their pockets to spend on other things.
None of this is to say you shouldn’t rebalance your portfolio to reflect shifting realities. (Maybe holding nothing but Canadian energy stocks isn’t such a great idea when the world is awash in oil.) And holding shares in a dud company out of some misguided attachment is just plain silly. But just because the headlines scream fear today is no reason to do something stupid you’ll regret tomorrow.
This story originally appeared on Macleans.ca
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