Should we be worried about the recent falls in stock markets?

No, but read on to find out why:

It looks like the market will finally get something that happens, on average, about once a year: a 10+% percent drop—the definition of a market correction.  They aren’t.  Corrections are unnerving, but they’re a healthy part of the economy—for a couple of reasons.

Reason #1:

Because corrections happen so frequently and are so unnerving to the average investor, they “force” the stock market to be more generous than alternative investments.  People buy stocks at earnings multiples which are designed to generate average future returns considerably higher than, say, cash or bonds—and investors require that “risk premium” (which is what economists call it) to get on that ride.  If you’re going to take more risk, you should expect at least the opportunity to get considerably more reward.

Reason #2:

The stock market roller coaster is too unsettling for some investors, who sell when they experience a market lurch.  This gives long-term investors a valuable—and frequent—opportunity to buy stocks on sale.  That, in turn, lowers the average cost of the stocks in your portfolio, which can be a boost to your long-term returns.

The current market downturn relates directly to the first reason, where you can see that bonds and stocks are always competing with each other.  Monday’s 4.1% decline in the US S&P 500 coincided with an equally-remarkable rise in the yields on U.S. Treasury bonds.  Treasuries with a 10-year maturity are now providing yields of 2.85%–hardly generous, but well above the record lows that investors were getting just 18 months ago.  People who believe they can get a decent, relatively risk-free return from bond investments are tempted to abandon the bumpy ride provided by stocks for a smoother course that involves clipping coupons.  Bond rates go up and the very delicate supply/demand balance shifts, at least temporarily, in their direction, and you have the recipe for a stock market correction.

This provides us all with the opportunity to do an interesting exercise.  It’s possible that the markets will drop further—perhaps even, much further.  Or, as is more often the case, they may rebound after giving us a correction that stops short of a 20% downturn.  The rebound could happen as early as tomorrow or some weeks or months from now as the correction plays out.

Once it’s over, no matter how long or hard the fall, you will hear people say that they predicted the extent of the drop.  So now is a good time to ask yourself: do I know what’s going to happen tomorrow?  Or next week?  Or next month?  Is this a good time to buy or sell?

The fact is that while it is possible to assess the relative state of financial markets in the sense that they may appear to be expensive or cheap, it is not possible to know exactly how expensive or cheap they are and importantly the best time to buy or sell. This is because market timing is about short term speculation, while investing is about assessing the current situation and taking a long term view.

Our view is that the current market correction is good news as it had  become increasingly difficult to find value in the markets due to valuations that had become hard to justify. While we cannot predict the which way markets will move in the shorter term, history shows us that they always recover, though this may take some time. History also tells us that the riskiest time to leap into markets is when they are booming and there’s lots of optimism around.  In fact it is much less risky to invest in times of doom and gloom, but most people find this psychologically challenging.

Peter Rodgers
Peter Rodgers
Peter Rodgers, the founder of Direct Advisers, holds a Bachelor of Arts degree and has been a practicing financial planner since 1986. With a background in law and economics, Peter is particularly skilled in understanding investments and investment portfolio construction. His main role is developing investment strategies for clients.