The current stock market correction was inevitable and was long overdue. There were plenty of indicators and smoke signals steaming from overvaluation. But one thing is that market corrections aren't predictable. You never know when it will happen and what will be the catalyst behind the correction. This time the smoke points straight to China as the main culprit. Well who would have thought that? Wasn't it not too long ago that China was the place to be? Everybody was talking about China as the next big thing. "The next century belongs to the Far East". Most financial pundits looking for the trigger behind a potential correction were pointing to the next recession or the day the Federal Reserve finally raised interest rates. Unfortunately it's never that clear and simple. You never see it coming. One of the worst myths out there is that the market is always rational and makes sense. The market can be totally wacky for reasons that do not make sense. Sometimes stocks go up when they should have gone down, and sometimes entire sectors move for ridiculous reasons. Prices can be volatile over the short-term without much explanation or correlation to underlying business performance. I was ready to blame the market collapse on Apple not meeting Apple Watch sales target (that's a joke in case my sense of humor is not apparent).
The current correction doesn't mean we are about to revisit the dark days of 2008-2009, the tech crash of 2000, or the Asian crisis of 1997-98. What's happening right now is also pale to the one day crash of 25% in 1987. By definition a stock market correction is a 10% drop in the index and has historically happened every 18 months. The fact that the U.S. market went nearly four years without one is historically unusual - it is the third-longest such streak in the last 50 years, according to JPMorgan Asset Management. What's happening right now has happened frequently in the past and will happen again in the future.
So why are we reacting so strongly about this? One reason is that people forgot what a correction feels like. We forgot what it feels like to be punched. Losing money hurts. When you see a stock plunging like a falling rock it feels like your stomach has dropped with it. It's sharp and fast. Others can't sleep. We are very sensitive to losing money. We are emotional beings and we make decisions based on emotions. That's when the subject of behavioral investing and psychology comes in. This time fear dominates and sometimes it translates into panic. And when panic takes over we do stupid things. "Long-term" investing goes out the window. To cut the pain investors click on the sell button. Funds have massive redemptions because investors demand their money which results in massive sales.
One reason why some people are freaking out more than others is because they don't understand what's in their portfolio. In good times the whole market goes up, even poorly understood momentum stocks (I bought company X because it will revolutionize the way we buy shoes). Holding sexy stocks provides good conversational material at a BBQ but it's not usually good for the wallet. After all you don't make friends talking about good old GE, that's why the maker of Candy Crush is now a public company. Voilà the importance of investing in high quality businesses that you understand. Companies that can withstand a tsunami. Ask yourself if this crisis impacts the long term cash flows of the businesses I own? Did the fundamentals change? One trick that helps to stay mentally calm is to visualize the cash flows of the company you invested in. Can you picture the cycle of money going from the customers all the way down to net income and then the dividend. Can you see the cash coupons? When you invest in a bond it's easy to see the coupon being distributed. Although it's more complicated with a company, it helps a lot if you understand how the company makes money and what the drivers behind it are.
Tune Out the Noise and Stick to the Plan
"Everybody has a plan until they get punched in the mouth." - Modern-day philosopher Mike Tyson
In general I'm not too crazy about financial advisors but there are a few good ones out there. But that's material for another post. Contrary to the popular belief, a financial advisor doesn't pick stocks for you (god bless). A good financial advisor makes a plan for you and makes sure you stick to it. That's really what their job is. They need to prevent you from doing anything stupid. You shouldn't abandon a carefully-constructed investment portfolio in favor of either panic or greed. Actually the plan set in place in calmer times is set up to capitalize on such periods of turmoil.
The financial media is not your friend. If the media preached the advice the financial advisor is giving you they would be out of business. In the next couple days or weeks the financial media will have a plethora of "market gurus" (fortune tellers) in the financial media hitting you with charts and numbers stating their case why the four horses of the apocalypse are coming. Forecasts such as, Dow Dropping to 5000 Starting This Year: Nenner, often hit an emotional nerve, such as anxiety, so investors naturally ask whether they should be worried. My advice is to ignore the fortune tellers. I don't trust their crystal balls. There's a joke in the industry regarding permanent bears (people who thinks the market will always decline and bring the apocalypse): "I've predicted 15 of the last 3 recessions". You get the point. Plus, it says a lot about their characters when you try to make living telling people how to time the market.
Here's the good news: The large majority of gurus are dead wrong. It's all for show. It's entertainment. Being loud and bold is their business. That's how they come back on T.V. It's not about being right. Being a colorful personality boosts ratings and as a result the network wants you back on. Who cares if you are wrong, nobody is keeping score. Why ruin a good game? It's not CNBC's job to protect listeners from bad things. CNBC's goal is to make money and you make money by having more advertisements which is achieved by having more viewers. Colorful personalities equal entertainment and entertainment equal ratings and good ratings equal more money. And for the few that get a right call once in a while, it's mostly due to luck, not an uncanny ability to see the future. No one is keeping these guys accountable for the forecasts they make. Here's the plain and simple true: No one has any clues as to where the market is going and to pretend otherwise is simply madness. My advice: You have to tune these guys out. Their goal is to entertain you (or to scare the crap out of you).
The point is, as an investor, you shouldn't ditch your financial plan because of some media or self-labeled "gurus" said something outrageous on T.V. If you keep watching they will have another guy on that will contradict everything. The secret about some of these guys is that they make more money off self-promotional strategies than investing ever did. How many fortune tellers are on the Forbes 500 list? Zero. How many economists? Zero. Do you think the world's best investors are acting on these forecasts?
"Be fearful when others are greedy and greedy when others are fearful" - Warren Buffett
The markets irrationally could be your opportunity for big profit. That's because falling prices create bargains. You have investors selling solid businesses at cheap prices. For more info on that I refer to Chapter 8 of The Intelligent Investor by Benjamin Graham where he introduced "Mr. Market", an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive the lad is, the greater the opportunities available to the investor.
I'm not saying to snap up shares just because they are beaten down. This is no different than selling because it went up. You need to do your research, look at the fundamentals, and figure out its valuation. You should take a private equity approach to valuing businesses. You should seek to buy businesses with a high margin of safety. Right now you should aim to capitalize on the mistakes many investors make based on human nature. Where impatience and emotions lead many to make rash decisions, I believe that a patient, disciplined approach allows you to remain rational throughout our process.
I don't accept volatility as the definition of risk. It's normal for prices to go down and have losses but what you don't want is permanent capital loss. A permanent loss of capital occurs when a stock goes down because of worsening business operations, or its earnings power drops permanently and stays down for a very long time or even forever. That's why it's important to do your own homework before investing in a stock. If you find an excellent business at a decent price, these crashes will look like tiny blips over a 10-year period.
"You are your own worst enemy" - Brian Langis and a bunch of people
Stay calm. The worst thing you can do is to panic. Acting out on panic will cause more damage. What's happening right now happened frequently in the past and will happen again in the future. A correction is normal and is ultimately healthy for a market because it removes some of the froth and speculation. If you can't stand these kinds of fluctuations then the stock market is not for you and that's ok. If you haven't figured out your temperament, the stock market is a very expensive place to find out. Stick to the plan. Long-term investing also works in falling markets. It allows you to dollar cost average. For the long-term investor, a stock market correction is often a great time to pick up high-quality companies at an attractive valuation. What do you think Warren Buffett is doing right now?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.