If you think of the "stock market" as a sort of nebulous entity that goes up and down every day, it can be easy to get scared and fearful about the possibility of a broad market selloff that drives prices downward. But once you take the next step and realize that the S&P 500 consists of 500 separate businesses with their own risk profiles, growth opportunities, and valuations, then you can realize there is much less to get fearful about. The power to individually scrutinize each individual holding in your portfolio and make a determination about undervaluation, fair valuation, or overvaluation grants the investor the ability to determine whether a price decline would constitute a warranted correction or an irrational decline driven by Mr. Market.
For instance, I happen to think that both Brown-Forman (BF.A) and Hershey (HSY) are excellent companies that should achieve 8-10% earnings growth over the medium term. But if I owned shares of either company at the present pricing, I would not be surprised in the slightest if a meaningful correction took down the price of either company. Value Line predicts that both companies will have long-term P/E ratios around 19-20x earnings. That is in line with the historical norms for both companies over the past decade.
If either of these companies experience a mean reversion with their P/E ratios, there should be a justified, permanent decline in stock price. Brown Forman (BF.B) trades at $71 per share, yet its rational valuation is around $55-$60 per share. Hershey trades at $90 per share, yet its rational valuation is closer to $65-$70 per share. These two excellent businesses seem well-suited for a meaningful share price drop that should not be surprising to investors that take into account the company's trading price history during the 2000s (the only way to justify these prices is to believe that the earnings growth rates of these companies is substantially improved now compared to the past thirteen years).
By the way, overvaluation is often a matter of degrees, and reaching the conclusion that a stock is overvalued is not necessarily an automatic sell signal. I happen to own both Procter & Gamble (PG) and Johnson & Johnson (JNJ), and while I believe both companies are modestly overvalued, I have no intention to sell either company. The world is simply not filled with people saying things like, "I wish I sold my Coca-Cola (KO) stock in 1994 when it was modestly overvalued!"
The rationale is that P&G and J&J are some of the most excellent businesses in the world. There's a very short list of companies that have business models built for permanent earnings growth of 7-12% annually, and I have no desire to relinquish an asset that is an "automatic wealth builder" just because its share price is 10-15% or so above what I would consider fair value. The reliability of the earnings growth and dividend growth over long periods of time make this situation tolerable. If I "lose" paper wealth in the form of a 10-15% haircut from these two companies, I will not be upset in the slightest because I expect the long-term earnings and dividend growth to give me reliable returns on a risk-adjusted basis. And if the market gets irrational and either of these companies drop by 20% or more, I will add to my holdings. That is how I prepare for a stock market correction with those two excellent companies.
And, of course, you have companies like IBM (IBM) that are likely undervalued in today's market. Right now, the stock is at $188. Sure, it could fall to $150, $140, or whatever. There is no controlling what Mr. Market can do. But we can be thankful that, to borrow a phrase from Professor Benjamin Graham, the stock market is a weighing machine in the long-run. IBM will be raising its dividend in the coming week or so. Earnings and dividends are expected to grow by a 7-11% clip over the long-term. Despite the revenue miss of 5% that spooked investors on Friday, the company actually reaffirmed its earnings guidance for the year. If management's prediction proves correct, this could likely be a good time to initiate a long-term position in IBM stock.
There is nothing to stop stocks from falling 30-40% in a short period of time. Just look at 2009. My job as an investor is to try to predict ahead of time which corrections would be justified, and which would be the result of unwarranted fear in the marketplace. If Hershey falls 20%, that seems like a return to fair valuation that is warranted. If IBM falls 20% in the coming months, it would likely result in a very good buying opportunity. If Procter & Gamble or Johnson & Johnson falls 20% in the coming months, it would likely represent a transition from modest overvaluation to modest undervaluation. If you speak in terms of specific companies, preparation for a correction becomes much more manageable.